Discussion
Today FED Governor Christopher Waller released a speech detailing updated guidance on the long-term direction of the Fed’s balance sheet. While the guidance is long-term in nature, I believe the bond market will begin to incorporate this guidance in the coming months, thus Waller’s speech is important, in my opinion.
In short: Waller’s speech tells me the Fed wants the long end of the UST curve higher. Look for a grinding move up in long rates to the September/October level (at least) in the coming months.
Waller’s guidance was simple, yet powerful - he wants to see two things:
FED Agency MBS holdings go to $0
1/3 of the Fed’s balance sheet held in T-Bills versus the current 3%
This means reinvestment flows will be concentrated at the front end of the UST curve and the private sector will need to absorb coupon paper.
All of this will take time. The Fed is incredibly slow-moving, and it really does not want to disrupt financial markets any more than is otherwise necessary. But this guidance was very specific and intentional. They know full well that holding excess long duration paper is weighing on term premia, as illustrated by closely connected FED watcher, Zervos (text from October 4, 2023):
Today I’m going to continue focusing on the Fed balance sheet, picking up where I left off on Sept. 19 in my last note, entitled “Are we still jacked up on the stock of QE?” In doing so I want to take everyone back to the end of 2019. At that time, the fed funds rate had settled at 1.75%, and the Fed balance sheet was just under $4t, or 18% of GDP. And on the economic front, the unemployment rate was at a 50+ year low, while inflation was running at just below the 2% target. If there was ever a time in history where monetary policy felt “neutral,” it was the end of 2019. Further, from the darkest days 11 years earlier, there was a sense that the greatest monetary policy experiment in history had successfully averted a second Great Depression. It was a peaceful, joyous, and most of all “neutral” time in those hallowed halls on the second floor of the Eccles Building.
Now, to be sure, the balance sheet had become much larger than the 5% of GDP pre-GFC. We permanently “monetized” a few trillion in debt during this policy experiment. And purists would likely argue that the balance sheet was well above its historically neutral levels. However, given the significant changes in bank regulation that occurred post the GFC, there was (and still remains) a belief that a permanent increase in Fed-generated liabilities was needed to ensure smooth functioning of the banking system. Those regulations required banks to hold more “safe assets,” and therefore this excess reserves/cash expansion was necessary. Without it, the financial system would be starved of newly mandated liquidity. It was the “new neutral” for the balance sheet. And with the dual mandate fully achieved, while funding markets functioned without a hitch, this looked like a perfectly reasonable narrative.
So today I want to run with this 18% of GDP number as the neutral balance sheet size for the post-GFC world. Maybe it’s a little more, maybe a little less, but I would argue it’s certainly as reasonable a guess as any. Therefore, when we were running the balance sheet at close to 40% of GDP last March, before rate liftoff and QT, it was WAY WAY WAY above neutral. And to be sure, we needed that extra stimulus. Zero rates were not accommodative enough to see the economy through the darkest times of the Covid crisis.
But today, in a period where the FOMC is looking to create a restrictive stance for monetary policy, the balance sheet sits at 30% of GDP. It has contracted via the $1t in securities runoff, as well as via the rapid increases in nominal GDP – but it’s still nowhere near neutral. We are off by 12% of GDP, which equates to an extra $3.2t. That’s a lot of stimmy!!!! Remember, QE1 was $1.75t, so we effectively STILL have almost two full QE1s of stimulus in our system beyond neutral!! No wonder the JOLTS data just ripped back up to 9.6m on Tuesday. But I digress!!
The important point in all of this is to understand that we cannot discuss a neutral level of interest rates, or more generally the overall stance of monetary policy, without speaking about the stance of balance sheet policy. And as shown above, the balance sheet is still in an extremely accommodative state!!
Now, way back in early 2009, when I had just joined the Federal Reserve Board as a Visiting Adviser, there were endless discussions on the sizing of QE1. There was no model, and there were no metrics, but plenty of attempts to crystallize some sort of numeric values on QE potency were on the table. Some argued that every $100b of QE was worth about 2–4bps in lower short rates; others thought it was closer to 6–8bps. Some thought it was even more than that. The trouble was that the FRB/US model only knew how to put interest rate impulses into its simulations, so someone had to translate QE sizes into rates space to quantify the economic effects. In the end, even years later, I’m not sure anyone ever felt comfortable with those rate-equivalent QE translation exercises. And to that point, Bernanke once famously said when asked about how QE actually impacts the economy, “Well, it works in practice but not in theory.”
But whether or not those exercises are legitimate, I think throwing a few concrete numbers down helps us think more clearly about the overall stance of monetary policy and neutral rate levels. As you might expect, given my longstanding love of QE and overall belief in its extraordinary powers, I was always more in the 6–8 camp. And if you come down my rabbit hole on this one, a ~7bps per $100b view suggests that the QE stock adjusted neutral rate would need to INCREASED by ~225bps at present. So, if it’s normally 1.75%, like at the end of 2019, it’s really closer to 4% today. Therefore, the current rate of 5.25% is hardly that restrictive, especially when we think about how much of an inflation overshoot has occurred in the last two and a half years.
The other way to think about it is that the current QE stock adjusted short rate is 5.25% minus 2.25%. So, we really have only a 3% short rate at the moment — hardly the restrictiveness that many believe is currently needed in the system.
So, what may be happening in markets right now is that a rate neutrality expectation adjustment is taking place. There is fast becoming a recognition that with all this embedded balance sheet stimulus, the Fed will need to keep real rates higher for longer. As such, longer-term real rate expectations (and real-rate risk premia) are ratcheting higher, while recession risk metrics are dropping. I would argue that is the single best explanation for why long rates are moving. It’s certainly not inflation expectations, which haven’t budged; and therefore it’s not Fed credibility. It’s just that the risk-weighted average of future short-term real-rate expectations has shot up. Neutral needs to be higher for longer, at least over the medium term. It’s that simple, until we get the balance sheet back to neutral in the next 2–3 years.
Now, I know lots of folks are running around with fiscal policy explanations for these rate moves. And I’m going to push back hard on that. Fiscal policy has been expansionary for a long while; and in fact, debt-to-GDP levels have been contracting recently from the post-Covid peak of 130%. The fiscal story is not new, nor is the fiscal policy story accelerating. But folks sure love to talk about it. I much prefer my story above. So, I’ll leave you with one other fact on this misguided notion that US long-term rates are rising because of some “fiscal policy run wild story” that the market just realized in the last quarter.