Reactions to the February FOMC - High Quality Credit Spreads

Dan Krieter:

Hello and welcome to Macro Horizons High Quality Spreads for the week of February 1st. Reactions to the FOMC. I'm your host, Dan Krieter here with Dan Belton as we bring you our immediate takeaways from the February FOMC meeting just after the conclusion of the press conference.

Each Week we offer a view on credit spreads ranging from the highest quality sectors such as agencies and SSAs to investment grade corporates. We also focus on US dollar swap spreads and all the factors that entails including funding markets, cross currency markets, and the transition from LIBOR to SOFR. The topics that come up most frequently in conversations with clients and listeners form the basis for each episode. So please don't hesitate to reach out to us with questions or topics you would like to hear discussed. We can be found on Bloomberg or emailed directly at dan.krieter, K-R-I-E-T-E-R, @bmo.com. We value and greatly appreciate your input. Well Dan, for a Fed meeting where they raised 25 basis points and everyone expected they would raise 25 basis points, this sure was an action packed FOMC meeting. Lots to unpack here, but why don't we just take it from the top with the statement. There were a couple things in there that I think were noteworthy.

Dan Belton:

Yeah, so the most anticipated portion of the statement was whether or not this committee would maintain the language about ongoing increases in the target range. And they did that and the market initially took that as a hawkish signal implying two more quarter percentage point hikes throughout the cycle. I wasn't terribly surprised about that. I was sort of on the fence as to whether they would alter that language, but the decision to keep it as consistent with the median December SEP. So not terribly surprising there. I thought the more interesting part of the statement was what was changed, which was the language around pace of future increases changing to the extent of future increases in the funds rate. And there's a couple different ways you can interpret that I think. I'd be curious to hear how you took that. I think one way that makes it sort of a non-story is that it implies that future rate increases, the pace is no longer uncertain, it's going to be 25 basis points.

Whereas another way that you could think about this is that it's suggesting that the FOMC was discussing at this meeting the possibility of a pause and they're talking now about the extent of future increases, how many more until we pause. And if you think back a couple meetings, I think it was November, Powell talked about how the Fed had transitioned to a different phase of the tightening cycle where in essence the question had shifted from the pace of rate hikes to the extent of rate hikes and where terminal would be. And so in that lens I think you could make the argument that that shift in language could have been more appropriately done a couple meetings ago and it would only really make sense to change that in the statement today given discussions around a sort of imminent pause. How did you take that?

Dan Krieter:

I hear your argument. I definitely took it in the first way you described that it just meant that future rate hikes will be 25 basis points and I think there's a couple pieces of evidence we can point to that kind of bears that out. I mean first, like you said a couple of meetings ago, we were still talking about 50 beeps versus 25 beeps. I mean the last meeting prior to this one they raised 50 and there was at least as of a couple weeks ago, some pretty lively market discussion as to whether or not they'd go 50 or 25 here. Then of course there's the fact that rate increases with an S was kept in the statement, which implies to me there's going to be more rate increases. So this just says they're going to be 25. And then although he did get a question about potentially pausing, he talked about the Bank of Canada pausing and then returning to hiking and that that was something the FOMC was not currently deciding on, I think was his exact words, I'm not sure.

But you put kind of all those things together and I think that the extent portion of the statement to me just locked in that it's going to be 25 from here on out and the only question is how many more 25s? Keeping increases in the statement certainly would suggest that that's at least two more, which would get us to an upper bound of five and a quarter as terminal and maybe this is a good way to transition to, there's a lot of discussion around the fact that market participants are pricing in cuts later this year, which the Fed has not yet messaged at all, but even this expectation where if we're just going to go strictly off of what the statement said, multiple increases of 25 basis points, we're going to get to at least 525 and that's not where market pricing is at all.

I mean, looking at implied probabilities right before we came in here, we have an implied probability for May of 4.88 in June of 4.89. So saying one more hike and that's it. So clearly the market is not only not listening to the Fed as regarding rate cuts later this year, they're not even buying into even after the February FOMC that we're going to get to a terminal of five and a quarter.

Dan Belton:

Yeah, I thought that was interesting too and I thought the more interesting part about it, and I guess we can just dive right into the press conference at this point was that Powell was given I think a couple times in the press conference an opportunity to push back on market pricing, to push back on easier financial conditions and he really passed on that opportunity. He even said that financial conditions are pretty much unchanged from the December FOMC. He said that financial conditions have tightened significantly from this point last year, which is true, but they've also come off a lot from their peaks and if you look at a few different measures of financial conditions, the Bloomberg Financial Conditions index is that it's loosest since February. If you look at the global financial stress index also it's easiest since February, the GSUS financial conditions index, which is probably the one that the Fed tracks most closely, that is still elevated, but that's at its loosest since August.

So financial conditions have eased a lot and market pricing has come down a lot and Powell didn't really seize the opportunity to push back on that and that's what I thought was the most interesting takeaway from the press conference today and that's what I think was the biggest driver of this rally that we've seen in risk assets and in treasuries. And he kind of with respect to the market pricing and the divergence between market pricing and Fed forecasts, he just sort of said that we don't foresee rate cuts this year, but if we do see the data come in differently, of course that will play into our policy. I thought that was interesting.

Dan Krieter:

Yeah. I mean, you brought up the financial condition, so I want to talk about it a bit because clearly that was the most important aspect of today's meeting. Clearly the driver behind the rally in both equities and bonds here. And I think if you look at... He's really fielded two separate questions on easing financial conditions. One early in the press conference and one later in the press conference. And I thought it was somewhat interesting to note his responses to both. The first time he got the question he said, "We're not really focused on short term moves. Financial conditions are tighter now than they were a year ago. That's sort of the more important thing," blah, blah, blah. Then we got the second question later in the press conference. He said, "Financial conditions haven't really eased since December. They're sort of unchanged." So look at those two statements in a vacuum.

On the one hand he says they haven't changed since December, so we're feeling pretty good about it. But then he also says we're not focused on short-term moves when he brought up the short term move in the response to the second one. So those two statements, I mean, while short of contradictory, they don't make a ton of sense together and so to me it strikes as okay, he clearly came in prepared for this question. Of course he was going to be asked it, especially considering all the focus they've put on financial conditions in the past couple meetings and in some of their inter meeting Fed speak, and this was the message he came prepared to deliver. He wasn't going to say that financial conditions were going to be an impetus towards more restrictive monetary policy. Said differently, he's not going to use easy financial conditions as a reason to continue hiking.

Now we're just solely focused on core services ex-housing, which makes a 56% of core inflation. He talked about it a bunch of times in the press conference. That seems to be the only thing that's keeping them hiking and any of this potential for inflation expectations becoming embedded. If you see a dip and it comes back, then there's more chance to become embedded. So just being precautionary, waiting for that stubbornly high component of core inflation to come down. But regarding financial conditions, the most important thing by far here is it almost unwound to me all of the warnings they've been giving over. Well, we don't want to see financial conditions easing, it interferes with the transmission of monetary policy. It seems like all that went out the window today.

Dan Belton:

Yeah, and I think a lot of that is probably due to the evolution of inflation data that we've seen and that was clearly encouraging to Powell. He did mention that the core services ex-housing from the PCE report is still at 4% year over year and there's a six-month change, but he mentioned goods inflation coming down much more quickly than they had anticipated after remaining stubbornly high. He said that the disinflation that they've seen so far has been gratifying and I think more broadly there was just a lot more optimism from Powell today around the possibility for a soft landing. And that to me explains a lot of his willingness to accept easier financial conditions.

If he's expecting that inflation is going to come down more quickly than he had expected a few months ago, he's willing to accept easier financial conditions as a way of sort of preserving some of the economic fundamentals that have started to deteriorate here. And then just going back to his talking about a soft landing, he said in his base case he's expecting growth to be positive this year, which I think is more encouraging than I'd heard him sound for most of the last 12 months or more.

Dan Krieter:

Yeah, he has to be encouraged by how resilient the labor market has been in the face of all these rate hikes. In fact, it's the only reason why we're still hiking rates in some respects. So certainly I think the perception for the odds of a soft landing have increased for everybody, Powell included here. He even dusted off the old word transitory here, but now the other way with inflation, that inflation has come down particularly in the good sector and that you'd expect that to sort of reverse course with upward pressure on goods pricing coming down the pipeline. So he's actually saying here that upward pressure on inflation might come back and so if that proves to be misguided, inflation continues to drop much more rapidly than it seems he was expecting or in line with market expectations, the soft landing hope is certainly there and this is the Fed that's now sort of transitioning away from the fight against inflation.

I mean, obviously we're still fully in inflation fighting mode right now, but starting to lift the eyes a little bit to the next phase of monetary policy, which is going to be making sure we didn't over tighten. Right now, the risk is we have to make sure we don't do too little, but over the course of the next two, three meetings, that's going to transition to making sure we don't do too much. So maybe the first step there from the Fed is no longer pushing back against easy financial conditions given they don't become too easy. But I don't even know what that would be at this point. As you said, they've come down pretty significantly. So where does that leave us? I think we both see the impetus to the big rally in financial assets from the Fed electing not to push back against easier financial conditions, but we also have to go back to the beginning of the conversation here and say they also said there's going to be multiple rate increases still.

Their intention is to hold rates in restrictive territory unchanged for the foreseeable future. He doesn't see rate cuts in 2023. All of these things are restrictive monetary policy. So as we look at what it means for risk assets here, now we have two very different things coming from the Fed and the market's telling us one thing for sure, and I think that the market is pricing to... That the Fed is going to be able to come off that restriction rather quickly and they're going to return to an economy of stance maybe sooner rather than later. But that's what the market's pricing to now, that's what's baked into credit spreads. So with the Fed kind of now stuck in the middle, where do you see things moving in the next couple meetings, and where do you see that impacting risk assets?

Dan Belton:

Yeah, and I liked the way that you characterized that about moving to a point in the tightening cycle where they're no longer exclusively concerned with battling inflation, but now starting to look at the risk to over tightening, and that's a development that I think many in the market weren't expecting given just the size of the rally that we'd seen today in risk assets. But with respect to your question, I think the easy answer to it is it's going to really depend on the incoming data as Powell said, but if inflation continues to evolve as it has in recent months, I see no reason to expect the Fed to reverse course and all of a sudden skew much more hawkish.

And I think we'll get an early indication of the Fed's reaction function as soon as next week where we have the potential for Fed speakers to come out and kind of push back against this rally in risk assets and undo some of the dovishness that Powell displayed today. I don't expect that to happen. I'm curious if you agree with that or disagree with that. As we've seen in response to several other FOMC meetings, the norm for most of 2022 was that we'd see a rally in risk assets on the day of the Fed meeting and then speakers would come out the following week and kind of pour cold water on the market reaction and send risk assets lower. I'm curious if you think that that might be a dynamic that unfolds again next week or if this time it's different.

Dan Krieter:

I actually do think this time is different. I think this was a cognizant shift from the FOMC that we are not going to be fighting financial conditions anymore. If they're going to ease, that's not necessarily a bad thing as long as inflation is continuing to come down. So I would be surprised if that came out. And so now we're really shifting to the next phase of monetary policy here where we're going to see what the bar is for the Fed, how long they're willing to hold rates and restrictive territory given all expectations for the economy [inaudible 00:13:11]. Of course, that will be a function of how rapidly the economy cools, but where that bar lies is a huge uncertainty that's going to probably be the dominant theme in monetary policy going forward once we get through this last phase of hiking here.

So let's focus a bit on credit spreads here. Obviously, that's the focus for this podcast. We've seen an impressive rally here, 55 basis points plus now since October and pushing down towards 120 basis points on the [inaudible 00:13:35] index, really inarguably at the narrow end of the historical range and that's only become more rich after today's rally and risk assets. So where we are right now in terms of credit spreads already very narrow and a pretty important development from the FOMC today that they're not going to push back on easing financial conditions. What's your thought on credit spreads? Can we see an appreciable move narrower from here?

Dan Belton:

Yeah, I mean you talked about the significant rally and I think that's reflective of a lot of different factors in the market, including technicals, which have been extremely supportive and today's price action is just indicative of the support that we've had from different buyers spreads ripping narrower as the press conference went on. I think we've talked about the different classes of buyers that have been in the market. The emergence of foreign buyers after being largely on the sidelines last year has been evident in this year. And treasury auctions, I think it stands to reason that they've been equally active in corporate markets. We've talked about pension demand earlier this week as a potential rotation away from equities in the fixed income as pensions become better funded, insurance companies have been a strong source of demand for 2022, and I think that's likely to carry over into 2023.

And so the technical picture is really strong. There's clearly a lot of money on the sidelines. I think we're seeing that today. And so I don't put a hard lower bound on how narrow credit spreads can go. I mean, we're coming off of January, which was the second best month in terms of total and excess returns in over two years. And I think given that we're now past this FOMC risk, we're well into earnings season and despite earnings coming in lower than very low expectations, credit spreads have continued to perform and I don't see anything in the near term that's going to derail them. So I'm fairly constructive on them near term. I think there's a lot of uncertainty that they're going to have to contend with later on in the spring, but at this point in the cycle, I think credit spreads could continue to go narrower.

Dan Krieter:

Yeah, I mean, I can't argue with anything you laid out there. The demand statistics have been extremely strong. There's no reason to think that will continue, and particularly in the light of today's FOMC meeting, it does seem like spreads are going to continue narrowing. I don't know, call me the eternal pessimist or maybe bond market strategist, but I just think that these levels here, it's going to be very tough to justify them going forward in 2023. These levels we've only really seen historically during periods of usually monetary policy accommodation where we're looking for yield grab, reach for yield type environment, low volatility environments, and maybe that's what's going to come out of this, and maybe I'll be proven wrong, but I still think that there's going to be significant headwinds to the consumer to earnings that have yet to be priced in and we're going to see a move wider.

So I agree with you. The near term momentum certainly is carrying spreads narrower here, but I will... We've been maintaining a neutral weight here. I will certainly be, at least in my personal view, looking to move underweight, looking to take profits here, move up in defensiveness. I mean, coming into the year, we were expecting Q1 to be a very supportive environment for credit spreads. We had 120 basis points on the [inaudible 00:16:30] index as our target for lows in Q1. We're there now, and I'd say that the quarter has mostly unfolded according to expectations. Yes, inflation is coming in maybe a bit more rapidly than I thought. I thought we would see some stickiness and it's falling rather rapidly. We've seen the Fed turning. We were sort of expecting that, this financial conditions turn today, maybe also a bit surprising, but I guess what I'm trying to say is high level, things have played out generally the way that we expected it.

It's going to be the next move here where we see what the Fed does and we see how quickly the economy cools. I think that's what will drive spreads wider. So I'm still of that view, but we'll agree with you that near term we're looking for more narrowing. Looking down my notes here, Dan, I don't think I have anything really noteworthy otherwise. We got a question on the debt limit. Didn't really say anything. It's up to policymakers and we expect them to raise or suspend the debt ceiling. He mentioned the SEPs coming in March, really didn't give much guidance there. Basically saying they're data dependent and if we need to raise them, we will and vice versa. Evidence of a wage price spiral talking about Brainard here, she didn't see one. Powell agreed, but then sort of caveated that by saying, but once you see it it's too late so we have to prevent that from happening. I think that's it for my notes. Anything else you had before we go?

Dan Belton:

No, I think that mostly covers it. Let's wrap up there. Thanks for listening. Thanks for listening to Macro Horizons. Please visit us at bmocm.com/macrohorizons. As we aspire to keep our strategy efforts as interactive as possible, we'd love to hear what you thought of today's episode. Please email us at daniel.belton, B-E-L-T-O-N, @bmo.com. You can listen to this show and subscribe on Apple Podcasts or your favorite podcast provider. This show is supported by our team here at BMO, including the [inaudible 00:18:25] Macro Strategy Group and BMO's marketing team. This show has been edited and produced by Puddle Creative.

Speaker 4:

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