M&G: Federal Reserve meets market expectations

11 juni 2020

Jim Leaviss, Head of M&G's Public Fixed Income team, comments on the U.S. central bank's announcements:

To support the flow of credit to households and businesses, over the coming months the Federal reserve will increase its holdings of Treasury securities and agency residential and commercial mortgage backed securities.  It will do so at least at the current pace to sustain smooth market functioning, thereby fostering effective transmission of monetary policy into broader financial conditions. Rates will remain unchanged, with the zero bound expected to remain through to the end of 2022. There will be a continuation of asset purchases to the tune of $80bn a month of Treasuries and a further $40bn of MBS.

Market reaction

The reaction of treasuries and the USD to this news was muted, with the benchmark 10 year yield initially up at 79bps, only to continue to rally back to 74bps, whilst the 2 year yield is unchanged at 17bps. Having been weaker over the month, the USD weakened further during the press conference as Chair Powell delivered a reminder that the Fed isn’t here directionally to change prices in the market. It is hard to surprise the markets right now after all the central bank support, but this provides clarity and a degree of forward guidance as to how the Fed has decided to navigate these uncertain times. This leaves open the possibility of yield curve control in the future.

Market expectations

The Fed would have had to deliver something along the lines of yield curve control in order to outperform markets expectations today. Central Banks have been adopting the Spinal Tap model of turning it up to 10 and then 11, getting louder and louder. This feels like the start of some normalisation of central bank narrative. The outlier among the central bank movers recently has been the ECB, choosing to keep rates on hold at negative 50bps and instead injecting huge amounts of stimulus through asset purchases. This sends a message that perhaps negative rates don’t work after all and that this is therefore as low as rates will go in Europe. In this FOMC press conference, not one person asked about negative rates.

Outlook

The Fed has 3 remits: inflation (price stability), unemployment and keeping long term interest rates low. Even if the Fed thinks that asset prices are too high, if they focus on moving these in a direction they fail their remit of price stability and unemployment. What is certain is that there is an excess demand for safe assets right now, companies have drawn down the maximum revolving credit facilities and demand for money will increase with increased risk aversion should conditions deteriorate once again. Might the US follow the UK version of the playbook as in post WW2 times, when debt to GDP reached circa 200%, fuelling financial repression and forcing banks, insurance companies and pension funds to hold government debt? Or might the growth rate in the US post crisis be enough for them to grow their way out of the debt mound, given that rates are likely to be lower than future growth for some time?

We were looking for reassurances that the Fed’s willingness to continue providing extraordinary support for the economy will continue, and for a narrative of how long rates will be kept in the overnight target rate range of 0-0.25%. That we received in today’s decisions and the following press conference.