A Minute to Discuss the Fed’s Meeting and Plans

The Fed released minutes from its March meeting Wednesday, and normally, we don’t much rate these things. If you have ever tried reading Fed minutes, you know they are a sleep-inducing, jargon-laden slog that reveals precious little. But every now and then they stir up sentiment and stoke volatility. Such was the case yesterday, when the minutes allegedly revealed the Fed plans to tighten monetary policy even more than expected. Unsurprisingly, pundits blamed the announcement for the S&P 500’s Wednesday drop (which the index partially reversed Thursday). We don’t see anything negative in the Fed’s plans, though. Don’t get us wrong, we are always watching for Fed error, and we never underestimate central banks’ ability to foul things up. But in this case, their plans don’t seem likely to knock the economy or stocks any time soon.

Headlines focused on two nuggets in the meeting minutes—some members’ belief that a 0.5 percentage point (as opposed to the usual 0.25 ppt) rate hike may be necessary, and the revelation that the bank will start letting assets run off its balance sheet at a $95 billion maximum monthly rate starting in May, which echoed remarks from Fed Governor Lael Brainard earlier the same day. The general perception: The Fed let inflation get away from it and now has to tighten the screws hard to fix it. Some pundits already warned of impending recession because their favorite segment of the yield curve—the 2-year/10-year chunk—inverted, and now they reckon aggressive tightening makes this a foregone conclusion.

To which we say: Hold your horses. Rate hikes may be tightening, but in our view, shrinking the balance sheet is not. As long as the Fed continues reinvesting all proceeds from maturing bonds, it exerts downward pressure on long-term rates. Pressing long rates down while raising short rates would flatten—and risk inverting—the yield curve. But, if the Fed’s minutes are to be believed, letting assets roll off its balance sheet—at about twice the pace it did in 2017 – 2019—takes that artificial dampener off long rates, which should help keep a decent margin between short and long rates. In our view, this could very well help preserve the yield curve’s recent steepening for a while.

Yes, steepening. That 2-year/10-year segment? Meaningless. Those who focus on it watch the yield curve for the wrong reasons. They argue that when 10-year yields fall below 2-year yields, it means investors expect bad times ahead and are willing to accept rock-bottom yields to avoid them. Maybe so, but that doesn’t cause recession, and we don’t think it explains the yield curve’s predictive powers.

The real magic, in our view, comes from the curve’s relationship with bank lending. Banks borrow at short-term rates and lend at long-term rates. The spread between them approximates banks’ net interest margins. When it is wide, credit is plentiful, pumping capital into the economy—fuel for growth. When it is flattish, banks lend to only the most creditworthy, which points to slower growth. When it is inverted deeply enough for long enough, it can freeze credit as lending becomes unprofitable.

Banks don’t get much funding via 2-year CDs. Most of their liquidity comes from checkable deposits and interbank funding, which we think 3-month rates best approximate. On the long end, the 10-year US Treasury yield is the reference rate for most loans. Ergo, we think the spread between 3-month and 10-year yields is most meaningful. It also happens to be at its widest point since 2017. Rate hikes will probably shrink this spread. But considering it is at 1.94 percentage points as of Wednesday’s close, there is considerable room for the Fed to hike without causing trouble—especially once the Fed stops sitting on the long end of the curve.^[i]

Now, we don’t think long rates are likely to soar from here. Consider 2017, when the Fed last let its balance sheet shrink. The bank announced its intent to normalize policy that year at its June meeting, formalizing the move in September. Rates bounced around rather directionlessly, as Exhibit 1 shows.

Exhibit 1: 10-Year Yields in 2017

Source: FactSet, as of 4/7/2022. 10-year Treasury constant maturity yields, 12/31/2016 – 12/31/2017. Dates of Fed events drawn from Federal Reserve press releases.

It won’t surprise us if something similar happens this time. Markets are forward-looking and don’t take long to discount policy changes’ impact. Once they do, other things have more influence in pushing rates to and fro. So, the risk of the Fed eventually inverting the yield curve isn’t absent. But we are a long way from that point, and nothing the Fed signaled yesterday makes it likely to arrive sooner, in our view.

Also, note: None of these plans are etched in stone. The Fed changes its mind all the time. Market expectations also shift frequently, so fed-funds futures markets aren’t a self-fulfilling prophecy, either. The Fed could wake up, realize this inflation doesn’t stem from monetary factors and rate hikes aren’t solving it, and shift course. We have a hard time seeing them do something so sensible, but you never know. Either way, however, even if people don’t consciously realize that simultaneous rate hikes and balance sheet unwinding aren’t actually tightening, markets will see it—they always do. Fear can trigger short-term negativity, but as markets weigh fundamentals in the mid to longer term, a growing economy should stay on the scale.