The Fed’s “Solution” To The Mess It Created: It Will Tighten And Loosen At The Same Time

By Michael Every of Rabobank

So, the Nvidia earnings came and went, with talk of the economy at an “AI tipping point”: it seems equity markets avoided one for now anyway. Before continuing on a purely financial front, allow me to share a few other headlines of relevance to markets that you may have missed.

Iran sent Russia 400 ballistic missiles for use against Ukraine. Europe just ramped up its sanctions vs. Russia yet again, including secondary sanctions on Chinese and Indian firms for the first time, ahead of an expected US move tomorrow; yet as @laurnorman of the Wall Street Journal puts it: “If this is correct, the EU has a BIG decision to make. Senior EU officials have said this would be a red line, necessitating economic sanctions on Iran. That would be the final nail in the coffin of the JCPOA. So let’s watch closely to see if they act or not.” Indeed, because so far neither the EU or the US will touch Iran ‘because oil prices’ – and Iran knows it and acts accordingly.

The head of the International Maritime Organisation warned ships avoiding the Red Sea are now at risk of piracy off Somalia, on Africa’s east coast, and Guinea, on its west coast. This threat was flagged in “Same Ship, Different Day’, and could exacerbate the current crisis: it risks even higher freight insurance costs and/or the need for larger, more expensive, longer-term naval escorts for commercial shipping.

The White House announced $20bn to improve US port cybersecurity. (And also cancelled another $1.2bn of student loans despite the Supreme Court saying this shouldn’t be done.)

The UK Parliament mirrored the Royal Navy’s nuclear deterrent in embarrassing itself with the world watching. Yet ignore the shenanigans to note The Times’ @Dannythefink underlining: “The Speaker of the Commons has announced that he ignored precedent and selected motions because of MP’s concerns of violent retribution if presented with the usual alternatives. This is not a Westminster issue, it’s a democratic crisis if it’s true. So we need to find out if it is.” Recall Justice Minister Freer stepped down recently claiming he had avoided murder “by the skin of his teeth.”

And so back to markets, where yesterday saw an ugly US 20-year Treasury auction with a record tail of 3.3bps, foreign bidders dropping to under 60% from 74% in November, and dealers left with 21% of the auction, double the November level.

That was preceded by the January FOMC minutes, which sent the message: “Not So Fast”. However, there was a second message: the Fed will start tapering QT after March. As our Fed-watcher Philip Marey notes, with some at the Fed now saying the QT balance sheet runoff could continue even after they begin to cut rates: “Monetary policy tightening and loosening at the same time, why not? Not long ago the FOMC considered this inconsistent. But who needs time-consistency these days?” Indeed: because the Fed will, for now, keep rates high (tight) while reducing QT (looser). This kind of hybrid policy has long been flagged here as a ‘logical’ solution to the mess the Fed, and other central banks, have gotten themselves into.

The Fed’s Bowman was even clearer that the time for lower rates is “certainly not now.” Philip, who was saying 3 cuts when the market was saying 6, and no cuts in 2023 when the market was salivating, is sticking with the first of three 2024 Fed cuts in June. However, he adds: “the coming months should reveal whether the recent inflation stickiness is a one-off… we cannot rule out that progress on inflation is stalling… If keeping policy rates at current levels for longer is not going to do the job, the FOMC might even have to think about hiking again. However, they may prefer to delay that decision until after the November elections. Testing the limits of Fed independence may be hazardous in the current political climate. Before they know it, they will be buying green and blue bonds!”

The key point for markets is not the ‘mean’ central bank minutes, but that our (geo)political and economic problems mean central banks are minute. They are not now the giants that we like to conceive. There are limits to what monetary policy can do. More of the action going forward is going to be in the fiscal space, with the real issue being if the central bank cooperates with the government or not. That’s a whole new ballgame for Mr. Market.

Echoing that trend, the Bank of Thailand just pushed back against government efforts to force it to cut rates. As the Bangkok Post puts it, their reply was: “If we lower rates, it’s not going to make Chinese tourists spend more, or cause Chinese firms to import more petrochemicals from Thailand, or cause the government to disburse the budget more rapidly.”

In New Zealand, inflation expectations surged for the 2-year and 5-year segment despite being in recession. Our Australia and NZ strategist Ben Picton says that this now puts our ‘no change’ call for the RBNZ next week into question.

The BOE’s Greene notes upside risks to inflation from the Middle East, and that the supply side of the UK economy is constrained (which rates can’t change). We concur with both assessments. And as the Financial Times notes today, “Flawed labour market survey has left rate-setters unsure on even basic questions such as the level of unemployment.”

In Europe, provisional manufacturing PMIs for February showed France at 46.8 vs. 43.5 expected, yet Germany at 42.3 vs. 46. French services were at 48.0 vs. 45.6 consensus and German at 48.2 vs. 48. The overall Eurozone PMI was 46.1 for manufacturing and 50 for services. Tell me, what level of rates helps a bifurcating European economy with structural deindustrialisation yet a gradual upswing in services helped by rising real wages?

It’s all enough to make even the most swollen central bank heads feel a little small.