After QE Comes Yield Curve Targeting By Both The Fed And The Treasury

by: Adam Whitehead


The Republican consumer has taken up the indebted heavy lifting from the corporate sector which will prompt the FOMC to react swiftly.

A rate hike in March is expected but what happens next with little hard evidence on the Trump stimulus is a more interesting question.

Chairman Yellen has signaled that the FOMC will adopt a yield curve targeting strategy but this is not official policy yet.

The Treasury is rolling out its stimulus plans into the future whilst cutting its economic growth target simultaneously.

The strategic wobble at the White House is evident in a pivot to the political middle ground.

(Source: Kaplan Genesis)

The US Treasury and the Fed are embarking on a strategy of yield curve targeting. Both strategies involve yield curve flattening. The Fed's strategy is deliberate, whilst the Treasury's appears to be inadvertent and contrary to its initial steepening signals.

(Source: Calculated Risk)

The last report highlighted the subdued credit creation reported in the Fed's latest quarterly loan officer survey. This is unlikely to prevent the Fed from promptly continuing its interest rate rise process however, in the wake of the latest report from the New York Fed on consumer credit creation in Q4/2016. The consumer took up the heavy lifting from the corporate sector in Q4 and advanced its indebtedness to levels close to the pre-Credit Crunch peak. Student loans and auto loans were the main drivers, so enthusiasm for a broad based credit expansion should not be raised unduly. Indeed the concentration of risk in these two categories hints at problems to come as these debts become unsustainable at higher rates of interest.

(Source: Woolf Street)

The student loan bubble is a subject that is well known. The rising delinquency rate, in the auto loan sector, is evidence of a bursting bubble that may be less well known however. The fact that these two sectors are driving the credit creation process is not something that should inspire the FOMC to be aggressive with its interest rate rises.

(Source: Gallup)

Neither should the rising level of Daily Worry that the consumer has been experiencing since the election.

(Source: The Daily Shot)

The jump in consumer sentiment post-election has a decidedly partisan split within it. Probing beyond the Electoral College headline, the election result showed that a significant majority of Americans did not vote for the President. This divergent sentiment has a profound context that should be a cause for concern if it persists, especially if it gets worse. The economy is clearly not firing on both cylinders at present. Despite these warning signs, the FOMC has recently collectively hinted strongly that it will raise interest rates in March.

(Source: The Daily Shot)

Fed Vice Chair Stanley Fischer cautiously affirmed Chairman Yellen's testimony signal that the economy is on track to have three interest rate hikes inflicted upon it this year. His cautious tone was repeated by Cleveland Fed President Loretta Mester. Whilst she is "comfortable" with hiking rates immediately, she contradicts this view by saying that the Fed is still "not behind the curve" if it does nothing. Minnesota Fed President Neel Kashkari sees even more room than Mester for the FOMC to hold off because inflation remains benign in his opinion. Fed Governor Jerome Powell sees the risks to the economy as much more balanced, thus still favoring a gradual approach to rate hikes, which makes the March FOMC meeting very much a live one. Philadelphia Fed President Patrick T Harker is more positive on both the economy and inflation than his colleagues.

For San Francisco Fed President John Williams: "a rate increase is very much on the table for serious consideration at our March meeting" and "I (Williams) personally don't see any need to delay" raising rates."

New York Fed President William Dudley also sees that the case for tightening: "has become a lot more compelling."

Fed Governor Lael Brainard's has been keeping a watchful on global growth, which had tempered her enthusiasm for rate hikes in the past. Her view of the global picture now appears to be much more positive based on her recent comments. The combination of improving domestic and global economic data has now bolstered the case for a rate hike in her opinion. This recent conversion of Brainard, in addition to the latest commentary by Dudley, appear to have influenced perceptions of the March meeting more than other Fed speakers.

Janet Yellen's latest speech at the Executives' Club of Chicago confirmed that consensus has been sought and created to hike at the March FOMC meeting. Interestingly, she adopted the perspective that hiking sooner and possible more than the expected three hikes this year will prevent the need to tighten more aggressively later. This rhetoric was clearly aimed at a bull market yield curve flattening.

A March rate hike is now viewed as a formality, but what is more interesting is the unfolding debate over what will happen over the rest of the year, with still as yet vague glimmers of President Trump's fiscal policy in view and absolutely no evidence in the data of its impact. Of growing importance also is the question of what if anything the Fed does with its expanded balance sheet.

Yellen's recent signal on the pace (or lack thereof) of balance sheet reduction was more interesting than anything that has been said about the pace of rate hikes. Allegedly she is in no hurry to reduce the size of the Fed's balance sheet through exit sales. What this means is that the upward pressure on long term interest rates from rate hikes, will be mitigated by the removal of fears of Treasury bond supply. The headwind to the economy from rising long-term interest rates will thus be reduced, which will in turn help to sustain economic momentum.

There is however a dark side to this benign growth enabling by the Fed. If it does not sell its balance sheet assets, this implies that when these bonds mature it will then reimburse the "profits" to the Treasury. If the Fed sells these balance sheet assets, then the Treasury will have to repay the private holders of them at maturity. If the Fed keeps the assets however, the Treasury in effect pays itself as the Fed must repay any "profits" back. Suddenly the budget deficit vanishes because the debts have miraculously vanished and in the meantime the Treasury actually has a cash surplus from the par value that the Fed pays back to it. This printing of money as some call it is the source of the President's fiscal stimulus.

When the debt profile of a nation is heavily reliant on short term Treasury Bill financing, this printing of money shows up very quickly and leads to potential hyperinflation conditions. Currently, the Fed and the Treasury have combined to roll this debt profile out into the future so that its hyperinflationary potential is less visible and hence less threatening. Since this Treasury bond maturity liquidity is not in the private sector but on the Fed's balance sheet, the management of this hyperinflation threat becomes easier.

As the future source of liquidity is on the Fed's balance sheet and not in the real economy there is an economic headwind. This headwind can then be overcome by the fiscal stimulus. This liquidity injection through the fiscal stimulus is also the potential source of the inflation that the Fed is raising interest rates in the in order to soak up. As the Fed plays this game of creating and mitigating inflation risk, it will have to apply the tool of yield curve targeting currently being used by the BOJ manage the situation.

This series of reports has noted Ben Bernanke's insistence that the Fed should attempt to engineer a bullish yield curve flattening through a combination of gradual rate hikes, rhetoric and pledge to reduce the balance sheet when interest rates are higher. This suggestion was belatedly embraced by Yellen in her recent testimony and has now been fully articulated in her most recent speech in Chicago. St Louis Fed President James Bullard, who it should be noted is a one rate hike and done in 2017 voter, has now taken issue with the yield curve flattening strategy. Bullard's rejection of three (or more) rate hikes this year and his rejection of the bull curve flattening strategy, puts him in a unique dissenting minority position.

According to Bullard, this strategy of flattening the curve has not been debated or voted on by the FOMC, even though it has become adopted as a policy tool. It would appear that the FOMC is being led blind in this strategy by Chairman Yellen. Bullard's eyes are open however, and for the record he now believes that the FOMC should go on the record and debate balance sheet reduction. Yellen may thus find it difficult to get this item off the agenda.

Bullard's logic is that balance sheet reduction is consistent with the cyclical reduction of emergency liquidity, now that the economy is reaching the Fed's dual mandate targets. As he succinctly puts it: "We should be allowing the balance sheet to normalize naturally now, during relatively good times." Applying his logic the FOMC is applying a pro-cyclical stimulus by maintaining an expanded balance sheet. Evidently Bullard does not think much of this stimulus because he is still only calling for one more rate hike, rather than multiple hikes that a counter cyclical stimulus would imply as being necessary. Attempting to read his thoughts, it would seem that he is anticipating economic softness in the future that may require the FOMC to respond with monetary stimulus.

Bullard therefore wants the Fed to create some fire-power today to deal with the weakness in the future. For now he is in a minority, as even if it is debated it is unlikely that balance sheet reduction is an imminent possibility. The targeting of a flatter yield curve will thus be official or unofficial policy in any event of a discussion and/or vote at the next FOMC meeting.

The minutes of the last FOMC meeting show considerable tension and debate, despite the fact that the general consensus is for three rate hikes this year. What is more interesting is how this debate and tension has evaporated in the last week. The debate was over the timing of the next rate hike, with those who believe that the risk in doing nothing is growing in conflict with those who would like a more thorough evaluation in the real economy of the impact of President Trump's fiscal policy.

The minutes were also notable for signaling that discussion about the reduction of the Fed's balance sheet, even if reduction itself does not occur, will occur at future meetings. Yellen has signaled that balance sheet reduction is conditional upon interest rates being higher, so this debate has already been anticipated and framed by her, thus allowing her to set the agenda and control the process. Bullard's recollection that balance sheet reduction has not yet been discussed is correct. The upcoming meeting will provide opportunity to do so, but only after Yellen has already framed the debate and set the tone.

The meeting was also interesting because it provided a new fig-leaf or rather fan, for the FOMC to hide its embarrassment in relation to forecasting behind. Going forward, forecasts will be augmented and supplemented by fan lines which will provide an error/guesstimate corridor around the dots. The Fed will thus to hide its forecasting issues in the confidence limits of the dispersal pattern fan lines, instead of facing the embarrassment of missing with its dot plots. This signals that the Fed has elevated the degree of uncertainty in predicting the future from this point in time.

(Source: Bloomberg)

Yellen's attempt to assert control, of the balance sheet debate and its narrative in the public domain, may just have received a warning shot from Treasury Secretary Mnuchin. The last report observed Yellen belatedly following Ben Bernanke's advice to engineer a bullish yield curve flattening through rhetoric and gradual raising of interest rates whilst keeping the balance sheet expanded. Secretary Mnuchin recently intimated that he intends to roll the profile of the Federal liabilities, that will balloon with President Trump's expected fiscal stimulus, out into the ultra-long end of the yield curve. He hinted at fifty to one hundred year bonds. By today's state of febrile sensitivity measures, long bond investors will not trust President Trump's credit out to this duration. He may just get away with more thirty year Treasuries. The curve will therefore have an innate tendency to steepen, based on discounting of this new debt mix, just as Yellen tries to prepare for her exit by flattening the it. This change in the shape of the yield curve being driven by fiscal policy is thus in direct conflict with that desired and under construction by the Fed. Furthermore as President Trump exerts greater control of the Fed going forward, as Yellen faces retirement/the sack and new appointees embed his intentions and capabilities within the monetary policy executive, the forces that are steepening the curve will get stronger. The rise in longer term bond yields will also have a stronger headwind impact on the economy going forward.

Over time, the Fed may then find that it becomes obliged to flatten the yield curve through buying more long duration bonds, rather than not selling the ones that it owns. The President's new Fed Chairman, assuming that Yellen doesn't make it, will most likely be someone who will accommodate this process. New Fed governor and president appointments to the vacant positions by President Trump will also be of the same mind. The rise in yields from the new fiscal expansion will levy a higher cost on the Treasury, which will then look to the Fed to mitigate this cost in the same way that the ECB and BOJ mitigate the costs for their own sovereigns.

In relation to the much hyped and anticipated tax overhaul, that the FOMC is keen to understand the economic impacts of, Secretary Mnuchin signalled that there won't be any clarity on the issue until at least August. This postponement of the expected good economic news will also serve to temper the FOMC's enthusiasm for rate hikes until its content and impacts can be seen and forecast respectively. Rumour out of Axios also has it, that similarly the highly anticipated fiscal stimulus will now be pushed back into 2018. The strategic rebalancing of fiscal policy signaled by the Treasury will boost defence spending at the expense of agency spending. Thus far this strategic rebalancing has been framed as deficit neutral, so once again the FOMC has very little to go on. In fact the cutting of agency spending and the general intention of the Trump administration, to cut regulations and make the Federal government smaller, may result in an uptick in unemployment as government and agency workers get fired.

The biggest bombshell from the new Treasury Secretary was his nonchalant striking of 1% off the target 4% for GDP that President Trump promised in his campaign. The biggest bombshell from the new Treasury Secretary was his nonchalant striking of 1% off the target 4% for GDP that President Trump promised in his campaign. Perhaps the new 3% target reflects all the sackings at the Federal government level. Evidently, Secretary Mnuchin is worried at the prospects of the Democrats who voted Republican swerving back to their Democrat origins, because he has elected to maintain the entitlement programs of Medicare and Social Security in his first budget. Maybe he is also worried about deserters of the Republican faithful, when they find that their populism is not subsidized by Obama era welfare payments. If the economic target has been lowered, then the safety net needs to remain in place to catch the disaffected. To further cement the loyalty of this financially burdened Middle Class voter demographic, members will be given tax cuts. Clearly these tax cuts are not expected to boost economic growth too strongly, as the growth target has been lowered to something that looks more attainable.

Suddenly, a pushing back of stimulus plans has morphed into a lowering of growth targets. It's not quite a U-Turn, but it is a policy reversal of some significance. As will be noted later, this wobble in confidence and swagger was also evident in the President's recent Congressional address. Optimistic expectations of the Trump fiscal stimulus are starting to look misplaced, in which case the Fed can relax some more. The further good news for Yellen in the cutting of the growth target is that it now reinforces her attempts to flatten the yield curve. The curve's innate tendency to steepen, from the new extension of the Federal Government's liabilities profile, has now been considerably mitigated by the lowered growth target. The bid for the long-end of the curve may now get strong enough, from the private sector, so that the Fed does not have to step up and buy after all.

(Source: The Daily Shot)

President Trump's latest Congressional speech did little to resolve the nagging questions about his fiscal policy. It also showed the strategic wobble in the White House and the realization that the swagger and rhetoric of the campaign and early days of the Presidency were misplaced. Political reality has dawned, along with the need to maintain the credulity of the nation and foreign observers. The reality of an imminent Congressional investigation of the President's connections with Russia may also have contributed the shuffle towards the orthodox middle ground. The latest revelation that the new attorney general and also the President's Son-in-Law/Adviser met with the Russian Ambassador during the campaign and have not made full disclosure of this was more smoke from a fire that is starting to burn out of control. As with Watergate it is not the actual events, but the conspiracy to obfuscate them that is proving to be most damaging.

The objectives of the President's Congressional speech were two-fold. He tried to remain true to his campaign promises, whilst softening his rhetoric to embrace the political middle ground. In consequence of these conflicting objectives, there was little of any substance other than rhetoric to gauge his future policy or its impact on the economy by. Once again, parsing the President the FOMC will struggle to read him and what lies in store for the real economy. His milder tone suggests that his position on trade will soften, which in theory lowers the probability of trade wars and thus gives the FOMC more conviction to hike. The lack of clarity on the stimulus, on the other hand, indicates that no urgency is required by the FOMC.

What is becoming apparent is that the visceral populism of the President has been captured by political and economic reality and harnessed, by a more pecuniary cohort within his team who are focused purely on the capital gains from their interchangeable cabinet and investment portfolios. Far from curbing the President's Twitter Tourette's , the pecuniary guys will indulge and encourage it. They will also indulge and encourage the tax cuts for the working man and woman. These inflammatory headlines are required to maintain the façade of populism, whilst they roll back rules and regulations that govern the economy in order to enable their Big Long. The President will now be able to indulge in his pastime of trash-talking on Twitter, for a narrowly defined uninitiated audience, safe in the knowledge that his rhetoric is not misunderstood by the initiated within his party and the broader electorate.

The FOMC now has to plot its course to make sure that rational exuberance is sustained, so that the liquidity sloshing about in capital markets does not start to create real price inflation by leaking back into the real economy. Investors must therefore be nudged backwards and forwards between the perceived relative value offered by bonds and equities, so that they never conclude that there is no value in either and become too enamored of Gold or cash. Targeting the shape of the yield curve is evidently about to become the new Fed tool in this perceptions game.

Commerce Secretary Wilbur Ross recently evinced the tactics of combining the President's attack-dog antics with negotiating skills of the pecuniary cohort in relation to Mexico. After the President's beating with the stick, Ross stated that a subtle acceptance of NAFTA defeat by Mexico could then be rewarded with the carrot of a more favourable trade agreement. Reciprocating with alacrity, Mexico's trade representative then made considerable conciliatory noises, whilst trying to appear undefeated with some semblance of a negotiating position, by averring that he would go to the WTO if American sanctions got out of hand. This cookie-cutter carrot and stick approach to diplomacy and trade now seems set to be scaled up globally with America's trade partners. The challenge for President Trump will be to present his acceptance of less than what he promised on his campaign as victories, assuming that his targets do not retaliate with sanctions of their own. Embracing the middle ground is the first signal that the President is attempting to do just this.

(Source: Business Insider)

The bond market can already smell blood, trickling from wounds opening up over the delays to the fiscal stimulus and the lowering of the growth target. Yellen's most recent yield curve flattening speech just whetted the bond market's appetite even further. The bid for Treasuries and for duration has come back. President Trump's attempts to place a large unity bandage over the political wounds in his team may have encouraged this quality bid even further. The Fed cannot have failed to notice the break in the correlation of higher yields and higher equity prices that had become the pattern since President Trump was elected. Whilst some observers are saying that equities are now vulnerable to the Fed tightening, there is a persuasive contrary opinion that both bond and equity investors have sensed that the Fed doesn't intend to follow through with a heavy handed rate hike process. Any further political problems for the President will effectively imprison him further in the middle ground; and in so doing drive the new divergence between equity prices and Treasury yields further.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.