The Breakdown - How Markets Are Interpreting the Fed’s First Hike Since 2018

Starting point is 00:00:04 Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexus.io, Arculus, and FtX, and produced and distributed by CoinDesk. What's going on, guys? It is Thursday, March 17th, and today we are talking about the absolute tightrope that the Federal Reserve is walking as they try to tighten monetary policy in the context of the country. of extremely hot inflation, slowing growth, and of course, serious geopolitical disruption in the form of both the war in Ukraine as well as in the context of Chinese COVID-19 lockdowns. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it wherever you listen to podcasts, give it five stars, leave a review, or if you want to get deeper

Starting point is 00:00:59 into the conversation, come join us on the Breakers Discord. You can find a link in the show notes are go to bit.ly slash breakdown pod. Also a disclosure, as always, in addition to them being a sponsor of the show, I also work with FTX. Now, we are back on our macro BS again, and it was Fed Day yesterday. This Federal Open Markets Committee meeting has been highly anticipated, and if you listen to this show regularly, you have most of the background. But in brief, 2021 from a Fed perspective, was transitory land. It was the great debate between the Fed who said that inflation was transitory, the product of dislocations that happened in the wake of COVID-19 that would naturally work themselves out, and the rest of the market who basically said, no, it's not.

Starting point is 00:01:48 As inflation kept creeping throughout the year, the Fed finally had to concede the point, and their language in tone shifted pretty dramatically in the late fall and early winter. The language changed around the Powell renomination, which was all focused on, focused on having the tools to fight inflation. By the December FOMC meeting, the Fed was talking about anticipated rate hikes, and in early January, we discovered that quantitative tightening, balance sheet normalization was in the offing as well. This, of course, was when markets really started to get spooked, and the broader macro context that we've been living in throughout 2022 really began. So, this March meeting that we just had yesterday was the first meeting where a rate

Starting point is 00:02:30 hike was expected. What happened? Well, just like anticipated, the Fed announced a 25 basis point hike. The vote for this was 8 to 1 with the only dissenting member of the committee actually wanting a 50 basis point hike. This is the first rate hike since December 2018 when we were at the 2.25 to 2.5% range. Now, in addition to the 25 basis point hike, the dot plot, which is the way that the Fed shows predictions, shows that their median forecast is for seven hikes over 2022 to an interest rate of 1.9%, and four more hikes in 2023 to an interest rate of 2.8%. Their summary of economic projections

Starting point is 00:03:09 has inflation moderating to 4.3% by the end of this year, which is simultaneously well above the previously projected Fed rate, but also a hell of a lot better than where we're sitting right now. So, in all of this, rate hikes were expected. Remember, it was not in fact rate hikes, but the threat of quantitative tightening that got markets really spooked. Now, it's worth pausing here to understand how quantitative tightening or balance sheet reduction actually happens. The general framing of it in financial media, this show unfortunately included, sometimes posits it as a simple process of the Fed selling assets back into market, although that's actually only one stage of many. Thomas Hogan from the American Institute for Economic Research,

Starting point is 00:03:51 the AER, published a piece about the four stages of quantitative tightening. The first is, perhaps obvious in retrospect, the end of quantitative easing. The U.S. has been buying assets since March 2020, since the beginning of the COVID-19 crisis. As of the beginning of March this year, two years later, we were still buying $20 billion a month in U.S. Treasuries and about $10 billion a month in mortgage-backed securities. The first part of any unwind of quantitative easing is a tapering of these sort of asset purchases, which has been happening in the U.S. since November of last year. The second phase of quantitative tightening is a stable balance sheet.

Starting point is 00:04:30 This phase means keeping a constant level of total assets for some period of time that the Fed determines, and this period can be as long or as short as they want. And how long or short that period is is, is again a key tool of monetary policy. Now, it's important to note that constant level of total assets will still involve some amount of asset purchasing. Why? Well, if the Fed wants to keep the total level of assets and the total duration or maturity of those assets constant, that means when bonds mature, the Fed has to reinvest into bonds of the same duration. Again, this keeps the dollar amount and maturity distribution of the Fed's assets constant across this stable phase. The third stage of QT is called passive tightening, and as it sounds, this still isn't an active selling of Fed-held assets into the market.

Starting point is 00:05:21 Instead, those same bonds that matured, which were re-bought in the second stage, the stable balance sheet, phase, are just allowed to mature without being replaced. As Hogan put it, the cash the Fed receives as proceeds from these bonds will cancel out some of the cash reserves that the Fed owes to commercial banks, reducing the assets and liability side of its balance sheet by equal amounts. The last time we saw this sort of passive tightening was 2018 into 2019. The Fed's balance sheet then shrank from $4.5 trillion to $3.76 trillion, about a 16.7% reduction overall. And then of course, finally, after all of this, there is stage four, active tightening. This is when the Fed would actually sell assets from its balance sheet into the open markets. It's worth noting, however,

Starting point is 00:06:08 that active tightening has never been used in a large scale to reduce the Fed's balance sheet. In his piece, Hogan also noted that even without active tightening, passive tightening is likely to happen faster this time around than in the period of 2018 and 2019, the last time we saw passive tightening. The reason for that is pretty simple. The average maturity, of Fed asset holdings this time around is shorter than pre-pandemic, which means that the strategy of not re-upping those shorter maturity assets will naturally happen faster. All of this is relevant as it seems the Fed is sending clear signals that this sort of passive tightening will be at the core of its QT approach. Basically, it said that this, quote, balance sheet runoff, allowing

Starting point is 00:06:48 holdings to expire rather than selling into the market, would be familiar to last time, only faster and earlier in the cycle. The Fed indicated that it had reached some working consensus, on how to go about this balance sheet reduction, and that, in fact, could start to happen as soon as the May meeting. Nexo is the go-to platform for all things crypto. Invest in the hottest coins out there and start earning risk-free interest of up to 20% APR, paid out daily. Need cash, ASAP, but don't want to sell?

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Starting point is 00:08:38 When you trade NFTs on FTX, you pay no gas fees. Download the FTX app today and use referral code breakdown to support the show. Let's get to some reactions, and the first of which I think is pretty clear is that there is not a lot of respect for this 25 basis point hike. Sven Heinrich, who you know as Northman trader on Twitter, said, a 25 basis point rate hike will mean nothing to fight inflation. 25 basis points is still running deeply negative real rates, and the market has already tightened far beyond a 25 basis point rate hike. The Fed remains far behind reality, and this is just a political exercise.

Starting point is 00:09:13 Material scientist writes, everyone is informed about 25 basis points and will bid feeling validated if it's in line with what they hoped for, until they realize that we're hiking into a recession and we're not just not printing money anymore, but we're also about to unprint money soon. 25 basis points versus 50 basis points is immaterial if you consider that CPI is at 8 to 10%. The upcoming rate hike doesn't even put a dent in real rates. Guys, even J-POW sold at the top late last year, in anticipation of all of this. Brian Chapata, the team leader at Bloomberg Wealth writes,

Starting point is 00:09:43 pretty amazing to read commentary around today's 25 basis point Fed hike. The Fed has now waged a war on inflation. There is a whatever it takes kind of mentality. Is that what a 0.25% or 0.5% Fed funds rate? Is it this level of inflation? Now what about the reactions to the tightening signals? Mohamed Al-Irean said, as expected, the Fed opted for a dovish tightening. Indeed, more dovish than many expected. With inflation being such a challenge, it is no longer a sure thing that markets will see this as a good thing. However, Danielle D. Martino Booth writes, markets loving Powell Wimpy on Balance Sheet. He's disclaiming his disclaimers. Some discussed the global implications to liquidity. Brent Johnson of Dollar Milkshake theme quoted Diane Swank, who said

Starting point is 00:10:24 the Fed doesn't understand that every time they raise rates, they force other countries to do the same to defend their currencies, adding at least a few people get it. Macro analysts, the Immigrant 84, writes, this is how you get a global liquidity squeeze. Powell forces everyone to tighten in order to protect their own currencies, and just like that, liquidity evaporates. A lot of the discussion was around the Fed's predictions and prognostications. Some pointed out that their predictions were the literal definition of stagflation, increasing inflation and slowing growth. AFP News writes,

Starting point is 00:10:54 Update, members of the Federal Reserve's policy setting committee also raised their U.S. inflation forecast for the year to 4.2% from 2.6% previously and slashed the growth estimate to 2.8% from 4.0%. Lots of discussions. as well about recessions and things left unsaid. Alex Kruger writes, Powell trying to answer how higher rates cool the economy by increasing unemployment without actually having to say it.

Starting point is 00:11:20 And when it comes to recession discussion, the sentiment that kept coming up from Powell and the Fed was, the economy can handle this tighter monetary policy. Alessio Urban pointed out, quote, the Fed has never predicted a recession. In 2008, everything was fine. However, the Bitcoin Shake replied with what I think is kind of a common-sense point, Yeah, I mean, do people really expect the Fed to ever say recession is on the horizon? It's like a coach saying, yeah, we anticipate a losing record next year. Still, going back to Northman Traders, Sven again, Powell, the risk of a recession into next year is not elevated. Nobody believes you. And this actually gets to an interesting market dynamic with all of this, which is stocks versus bonds. Lisa Abramowitz at Bloomberg writes stocks after briefly flirting with losses are now steadily rallying post-fed decision. There will be plenty of questions about

Starting point is 00:12:07 whether bonds and stocks are speaking past each other right now or whether they're sending a coherent message. Now, on the bonds front, we turn to a Bloomberg headline to get an idea of what that market is saying. Bond traders stunned by a hawkish Fed are sounding growth alarms. PBG macro writes yield curve implosion. Bond yields say Powell is wrong. The curve says recession. Then of course, there is this other larger point, which I think is supremely important to keep in mind anytime we're discussing the Fed or monetary policy shifts. Tracy Schuart writes, is anyone going to ask any hard questions? How does the Fed expect to quell inflation with real supply demand issues across broader commodities markets? Also, what impact does China have given that they have shut down major

Starting point is 00:12:49 manufacturing hubs and ports and disrupted supply chains again? These are some of the right questions, but to me, they aren't exactly a condemnation of Powell and the Fed so much as a question about how much power the institution really has at all. It is perhaps, in fact, us expecting all the answers to come from this group of nine people. That is the problem. Speaking of China, there is a lot of intrigue going on there, as just as the Fed tightens here in the U.S., the government seems to be easing in China. From Bloomberg again, Xi spurs frantic stock buying with lifeline for China markets. After a brutal 12 months for Chinese equities, Wednesday's session was looking like a tepid bounce off multi-year lows until the headlines started rolling from Beijing,

Starting point is 00:13:29 then greed quickly replaced the panic selling of the past few days. In a brief statement carried by state media, China's top financial policy body vowed to ensure stability in capital markets, support overseas stock listings, resolve risks around property developers, and complete the crackdown on big tech quote as soon as possible. While the pledges from President Xi Jinping's government offered little clarity over what authorities may do to achieve their goals, it was the first time China publicly addressed investors' top concerns in one coordinated scoop. The move underscored Xi's focus on ensuring economic and financial stability before a Communist Party Congress at which she's expected to secure at least another five years in power. It is the divergence that has

Starting point is 00:14:08 people's attention, and a lot of the discussion is still around the geopolitical shifts underlying the difference in these two markets. Robin Brooks, the chief economist at IIF, writes something big is happening in global capital flows. China is seeing big capital outflows while the rest of emerging markets gets inflows. Never happened before on this scale and reflects asset managers looking at China in a new light after Russia's invasion of Ukraine. So that is the story from Fed and markets right now. But there is so much more going on. There's more in crypto, where board apes just launched their own ape coin.

Starting point is 00:14:45 There is more in geopolitics, where the president of Ukraine is directly lobbying Congress for some sort of intervention or lifeline. There is, in short, a lot more to discuss the rest of this week. So for now, I will say thanks again to my sponsors, nexo.io, Arculus and FTX for supporting the show. And thanks to you guys for listening. Until tomorrow, be safe and take care of each other. Peace. Hey, Breakdown listeners, come join CoinDesks Consensus 2020, the festival for the decentralized world this June 9th through the 12th in Austin, Texas. This is the only festival

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The Breakdown - How Markets Are Interpreting the Fed’s First Hike Since 2018

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