One week ago, when discussing how the Fed had lost control of rates specifically highlighting the recent spike in the Effective Fed Funds rate above the IOER, i.e., the traditional ceiling in the Fed Funds corridor, which today hit an all time high of 5bps...
... we said that "the Fed might consider an imminent IOER reduction, possibly at the May meeting next week."
And as we learned today, not only did the Fed consider this, but went so far as to stun markets by pulling the trigger, or rather, the market may have been shocked, but our readers certainly were prepared for this "surprising" development. Confirming this initial "shock", the market's reaction suggested that its take on the Fed's announcement was seen as one of profound dovishness, only to sharply reverse just moments after, when Powell confirmed that the IOER move was entirely related to the clogged piping in funding markets, following his discussed of the "transitory" nature of inflation, sending the dollar and yields surging, and stocks tumbling as the Fed suddenly sounded like its old, mid-2018 hawkish self.
The reversal was painful enough to give traders whiplash, and as BMO's Ian Lyngen and Jon Hill wrote after the press conference, "we’ll be the first to acknowledge surprise (though not total shock) at the FOMC’s cut of IOER" although as they also note, the logic holds that the Fed wants to separate the "fine-tuning" being accomplished (i.e. keeping effective fed funds within the target range) from actual policy rate decisions. This point, Lyngen notes, was driven home during the press conference, adding that "the communications risk was always Powell’s biggest challenge for such an action and in this context, 2-year yields temporarily touching 2.20% and 25 bp on 2s/10s seems a small price to pay for the ‘needed’ policy tweak (not tweet)."
Additionally, as the BMO rates team observes, this was all completely reversed for an 11 bp round-trip for 2s, and summarizes that its biggest takeaway is that "Powell offered a material challenge for the cyclical resteepener and a ~5 bp range for 2s/10s."
Here's what else the BMO rates team though of today's violent reversal in the market's perception of the Fed:
There are two primary explanations for the initial bid; first, simply ‘the math’ of a drop of IOER and what that implies for a lower effective funds rate going forward (or at least a limit on how close to the top of the target range rates will be allowed to drift). The second driver is concern is that IOER has become the defacto policy rate – an assumption that Powell made great efforts to counteract during the press conference. The post-meeting volatility was extremely telling as the initial steepening was challenged as Jerome characterized the no-cut cut as ‘just technical’ in a remarkably matter-of-fact tone. Hats off for the delivery; the market responded quickly by cheapening up the front-end of the curve rather dramatically.
Powell noted the Fed doesn’t see a strong case for either a cut or a hike. This strikes us pretty intuitive; after all if there was a compelling reason, wouldn’t they have acted? More to the point, the Chair is trying to avoid pre-committing to any course of action at this stage. The conversation around inflation was similarly informative and with core-PCE currently at 1.55%, the groundwork for an ease is rapidly developing, we’ll argue at least, though if Q1 does turn out to be transitory the period on hold will be extended.
In the press conference, Powell was also directly asked about the possibility of a repo facility (which could help reduce the demand for reserves in equilibrium), and signaled two things. First, the FOMC is certainly going to be studying the topic at future meetings, as was previously hinted at in the March minutes. Second, however, Powell demurred on his bias as to whether such a facility was warranted, and indicated that he has no obvious leaning either way. This is consistent with our previous assumption that the introduction of this facility is far from imminent, though there are better than 50/50 odds that it will be rolled out by the end of 2020.
Tactical Bias: In classic ‘when the dust finally settles’ fashion we expect the true market impact from Wednesday’s events will not be known until after Friday’s employment report is released and wage data revealed. The focus on inflation isn’t a game-changer by any means; although it does deemphasize the strength in Q1 real GDP. Moreover, it offers another opportunity to re-trade the Fed into the weekend as AHE provides the next incremental piece of pricing pressure data. 10-year yields remain well-anchored to 2.50% -- yawn. The bulk of the Treasury volatility has occurred in 2s with an impressive 10 bp range (between 2.20% and 2.30%) speaking to the Fed-dependent nature of the rates market at this juncture.
We would also note an important nuanced counterfactual. Imagine that the FOMC hadn't acknowledged the descent in core PCE in the statement – the immediate takeaway would have been that the Fed has blinders on and isn't being flexible to lower inflation. Risk assets would have underperformed as calls of a policy error bounced around the echo chamber. Rather, the acknowledgment of disappointing inflation data helped provide a semblance of comfort to the market; Powell is clearly cautious to avoid a repeat of December.
In keeping with the message that the downward adjustment to IOER is more of a funding-market plumbing consideration than a true reflection of the stance of monetary policy, the reaction in the fed funds futures market to Wednesday’s decision was telling. The December ’19 contract was trading with an implied yield of 2.20% in the lead up to the technical adjustment, or pricing 25 bp of easing when taken against 2.45% EFFR. The reaction after the release of the statement was a 5 bp drop, and while dovish read on that move may be tempting, in fact the takeaway should be a net unchanged direction for policy. The adjustment to 2.15% on the Dec ’19 contract still reflects 25 bp of easing if the assumption is that EFFR will move back to 2.40% now that IOER has been adjusted to 2.35%.
And now the question is how quickly will EFF rebound back to 2.45% even with the IOER freshly trimmed down to 2.35%, confirming that with every passing day the Fed is increasingly losing control of overnight funding rates...