The Breakdown - The Fed Pauses For The First Time In 15 Months (But Don't Call It A "Pause"!)

Episode Date: June 15, 2023

For the first time since this hiking cycle began, the Fed has chosen not to raise interest rates. NLW explores how they're trying to control the narrative around it, and what markets think is actually going on behind the scenes.  Enjoying this content? SUBSCRIBE to the Podcast: https://pod.link/1438693620 Watch on YouTube: https://www.youtube.com/nathanielwhittemorecrypto Subscribeto the newsletter: https://breakdown.beehiiv.com/ Join the discussion: https://discord.gg/VrKRrfKCz8 Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW

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. What's going on, guys? It is Thursday, June 15th, and today we are talking about the Fed's rate pause, or is it a pivot? We will discuss it all in a little bit. Before we do, however, a quick note, you really should be checking out the Breakers Discord. It is a place to discuss the latest episodes, the goings on, in the industry, stuff that's happening in the broader economy, random hobbies, fun memes. It's all there, and you can find it at bit.ly slash breakdown pod.

All right, so as I mentioned, we are back on the macro side of things digging into yesterday's FOMC announcement and all the implications thereof. But one quick thing I wanted to flag. Coming either tomorrow or Saturday, we're doing a show about this massively strange Prometheum affair. If you've been on Twitter the last couple days, you've probably seen something about it, but here's the teaser. Prometheum Co. CEO Aaron Kaplan was one of the witnesses at a hearing before Congress on Tuesday.

Now, he was really a star witness for the Democrat position, given that he said that they had been able to register with FINRA as an alternative trading system just last month. Now, of course, if you've listened to this show, you know that Crypto's position has been that the SEC's notion of just coming in and registering is total BS. But if Promethium could, does that validate everything that Gensler has said? Indeed, Kaplan's views seem to be closely aligned with establishment Democrats, and frankly, at times in the hearing, he almost appeared to be reading prepared answers to highly specific questions. Now, towards the end of the hearing, Republican Mike Flood forced Kaplan to make it clear that under the terms of his

registration, his exchange was not allowed to offer Bitcoin or Ethereum. That, of course, questions how functional that kind of registration is in the first place. Now, that generated a whole new set of questions on crypto Twitter, where everyone put on their Sherlock Holmes hats and basically started digging into just what the hell is going on with this company. There have now been a seemingly endless string of interesting tidbits and innuendo, and I think it's worth digging into in full, so that is coming either Friday or Saturday. Today, though, of course, it is a J-POW day. Yesterday, the Fed FOMC announced its latest rate decision, and so of course every mainstream

tradfai market actor has been parsing every word, every first. phrase, even every intonation, to try and glean the future. So what did we get? Well, what we got was the first pause in the rate hiking cycle since it began about 15 months ago. Leading up to the meeting, discussions were swirling about the two overriding economic factors recently that were pointing in different directions for Fed policy. On the one hand, there is, of course, still too high inflation. Now, it should be noted that Tuesday's inflation report showed the CPI slowing to 4%, its lowest level in around two years, although core CPI, which trips out food and energy rose to 5.3%. But in any case, it appears that some of the more rapid decreases in inflation

recently have stalled above that magic 2% inflation target, which might suggest to some that further rate increases were needed. Now, on the other side of the coin is, of course, recent banking failures. Those failures were in part catalyzed by this rapid increase in rates, which had the unintended consequence of devaluing banks' reserve portfolios. Up to now, the Fed has deployed specific tools, notably the bank term funding program to deal with this issue rather than addressing it by slashing rates, but many feel that further rate increases would exacerbate the underlying problem deep within the banking system. So with all of those contradictory forces in mind, the Fed has taken a wait and see approach. The statement from the FOMC gave the explanation that, quote,

holding the target range steady at this meeting, allows the committee to assess additional information and its implications for monetary policy. Essentially what the Fed was saying is that they had decided to take in another six weeks' worth of inflation data as well as monitoring for further bank collapses before making their next move. Now, what was clear from the conversation is that despite this rate pause, the FOMC wanted to ensure that markets didn't interpret this meeting as definitively the end of the hiking cycle. This meeting saw the quarterly update to the Fed's statement of economic projections or SEP. Almost all FOMC members chalked up at least two more rate hikes to come by the end of the year. No members penciled in the end of the year rate cuts

being called for by the market. This change in forecast brings the expected terminal rate to 5.6%. And indeed, Powell spent the bulk of his press conference trying to get across the idea that the Fed isn't done hiking. He said that a continued decline in inflation is far from a sure thing, so that's why the Fed is maintaining the option to keep going. Powell said, we're two and a quarter years into this, and forecasters, including Fed forecasters, have consistently thought that inflation was about to turn down and have been wrong. If you look at core PCE inflation overall over the last six months, you're just not seeing a lot of progress. It's running at a level over 4.5% far above our target and not really moving down.

We want to see it moving down decisively, that's all. Hence you see today's policy decision both to write down further rate hikes by the end of this year, but also to moderate somewhat the pace at which we're moving. Indeed, that moderation of pace was the key framing for yesterday's decision. Powell argued that during the early part of the hiking cycle, speed had been key. With inflation moderating, however, he saw no need to move so fast to get to the end of the rate hikes. Speed was very important last year, he said. As we get closer and closer to the destination, it's reasonable to go a little slower. So what does this mean going forward? While Powell refused to give any guidance on whether to expect hikes in the July meeting,

he referred to that meeting as a live meeting. He said, the committee decision made today was only about this meeting. We did not decide or really discuss anything about going to an every other meeting approach or really any other approach. we were really focused on what to do at this meeting. He noted that inflation was well above target and that he was only seeing, quote, the earliest signs of disinflation in the non-housing services sector, which has been the main focus of inflationary pressures in recent months. Still, although meaningful progress hasn't yet shown up in the data, Powell was optimistic about the position the economy is in. He said, I would almost say that the conditions we need

to see in place to get inflation down are coming into place. That would be growth meaningfully below trend. It would be a labor market that's loosening. It would be goods pipelines getting healthier. The things are in place that we need to see. But the process of actually working on inflation is going to take some time. Now, the SEP, which again aggregates the forecast of FOMC members, showed expectations that this year's GDP would come in higher and the employment rate would remain lower than previously forecast, which led to questions about where that continued disinflation would come from. Now, this incoherent picture, with economic projections improving while inflation moderates, led some to question whether all of this meeting really just represented a trade-off between

doves and hawks on the committee to allow a decision to be put forward without dissent. In other words, hawks may have compromised to vote for a pause at this meeting in exchange for doves acknowledging that inflationary pressures are rising and more hikes could be needed to close out the year. Jeff Snyder said the hawkish pause is really a split FOMC. The hawks want to hike more, and if they're right, there's no reason to wait. Instead, there has to be others who are increasingly worried, correctly, about bank crises and massive recession risks. Now, others saw all of this as the Fed still aiming for that fabled soft landing.

Dario Perkins, the managing director of Global Macro at T.S. Lombard said, 18 months ago, central bankers were facing a calamity of historic proportions. Now they could be on the brink of a near-miraculous soft landing. We will never hear the end of it. In all seriousness, you can see why they are anxious not to eff this up now by overtightening. Their incentives have shifted. Last year, I wrote that investors needed to understand the viewpoint of central banks. They didn't want to become a case study in monetary failure. They would tighten rapidly even if that risked a recession, because it was better than the alternative, letting it happen again.

Now, the incentives have changed. They clearly believe they can pull off an improbable soft landing and have dodged the 70s, and having dodged the 70s, go down in history as a case study in monetary success. You can disagree, but I think you need to understand why this is significant. Why else are they so desperate to pause. They think there's a chance they can pull off the seemingly impossible. Otherwise, you just hike until everything breaks and recession is guaranteed. So what did markets think about all this? Inequities, not much, really. Both the S&P 500 and the NASDAQ saw a sharp sell-off as the decision was handed down, but then recovered to close the day almost level. This is more likely to represent market structure, with hedges against unexpected

policy being unwound, rather than a strong sentiment indicator. Over in crypto markets, the outcome was more negative. Both Bitcoin and Ethereum barely budged during the press conference, but as traditional markets closed, crypto markets dumped. Bitcoin plunged by almost 4% and bled out into the night. Ethereum fared no better, also chalking up a fast 4% drop, followed by a continuous decline. Hal Press, the founder at North Rock Digital wrote, My take for why we sold off. Fed was final catalyst for a while that was holding off shorts from pressing us through support. Once that passed, without a convincing positive result, there was nothing left standing in the way.

into the details of the press conference, what about some of the things that had been discussed previously? For example, for the past few meetings, Powell has characterized the fight against inflation as having three categories, consumer goods, housing, and services. His previous outlook was that goods disinflation was clearly observable in the data, that housing inflation data was laggy, but disinflation was likely already in the pipeline, and that services inflation, driven by higher wages, was the main issue to be addressed. This press conference had much, much less focus on the labor market, which appears to have peaked and begun to roll overall, be it slowly. Instead, attention shifted to housing, which has seen a resurgence recently.

Powell didn't seem too concerned as yet, but did note, we now see housing putting in a bottom and maybe even moving up a little bit. We're watching the situation carefully. I do think we will see rents and house prices filtering into housing services inflation. I don't see them coming up quickly, I do see them coming kind of wandering around at a relatively low level now, and that's appropriate. Now, from the press conference, it seemed that, if anything, the concern around a housing rebound was less that it would drive inflation higher and more that it would represent the removal of a disinflationary force slowing the overall process. Now, what about quantitative tightening?

Remember, one of the things that people have been worried about recently is the combined impact of ongoing quantitative tightening with the U.S. Treasury sucking liquidity out of the system at the same time now that a debt-sealing deal has been struck. This went almost without commentary at this meeting. At this point, the Fed has been attempting to reduce its balance sheet for 12 months. After a significant tick up in March to deal with the banking failures, QT has continued. The Fed's balance sheet is now back to where it started before the failure of Silicon Valley Bank. Overall, the balance sheet is contracted by around $700 billion from its peak of almost $9 trillion

in April of last year. Powell did address the Treasury's recent bond issuance required to refill the coffers after the debt ceiling was suspended. He said he had no concerns that the refilling operation would cause problems in the bond market, stating that, quote, Treasury has consulted widely with market participants about how to avoid market disruption and that they're going to watch carefully for that. And what about credit tightening? The big issue that was clearly front of mind was again these recent bank failures, or more acutely, whether there's more failures yet to come. Waiting to see if there are more

institutional collapses yet to surface seem to be a key reason for the Fed's wait and see approach. Powell said, since we chose to maintain rates at this meeting, it'll really be a three-month period of data we can look at. I think you can draw more conclusions from that than any six-week period. We'll look at those things and we'll look at the evolving risk picture. We'll look at what's happening in the financial sector. We'll look at all the data and evolving outlook and we'll make a decision. When asked about the collapse in commercial real estate prices, Powell spoke around the issue, but acknowledged that it would impair bank balance sheets, particularly for small and regional banks. We do expect that there will be losses, he said. There will be banks that have higher concentrations

and those banks will experience larger losses. We're well aware of that. We're monitoring it carefully. The larger problem on Powell's mind was clearly the prospect of a credit contraction as bank lending dries up. Now, while this concern had been palpable in the immediate aftermath of Silicon Valley Bank in First Republic, we haven't really seen data to indicate that banks have pulled back lending significantly. The issue for the Fed is that lending could dry up quickly and catch them off guard. During some prior hiking cycles, this has put the central bank in the embarrassing position of delivering a rate hike and then needing to turn around with emergency cuts shortly afterwards. It appears that this unknown quantity of credit tightening, that may or may not arrive in the short term,

was a big part of justifying a pause at this meeting. Powell said, if we were to see what we would view a significant tightening beyond what would normally be expected, we would factor that into account in making rate decisions. Basically, they're leaving themselves license if commercial banks begin to shut down to step in and cut rates. Overall, this is one of the more liminal fed meetings we've had. There are clearly contradictory forces in the economy that are bumping up each other. What's more, it seems like within the FOMC, who views one or the other of those forces as more important is definitely no longer any sort of consensus.

While J-POW came out and presented that consensus view, it feels like we're going to learn a lot about there being highly divergent feelings inside the Fed building that are factoring into this sort of wait-and-see approach. It is notable that certain things that have been hot topics in the past, including the labor market, weren't really in the picture this time. So, friends, that is the view from here. I think like the Fed, we're just waiting for more evidence one way or another. For all of us, it probably means that our slow summer of bumping along the bottom continues.

In times like that, you know, there's only one good piece of advice. Touch grass. Until tomorrow, be safe and take care of each other. Peace.