Playing chicken with Powell’s Pendulums (A Jackson Hole Primer)
Image: Pixabay
Jackson Hole starts this week, but so what?
Yeeha - this Thursday will see the start of this year’s economic symposium at Jackson Hole.
It’s an annual Woodstock for bankers where the Federal Reserve Bank of Kansa City welcomes a squadron of the world’s most senior central bankers, economists and thought leaders to prognosticate on economics in the cool shadows of the impressive Grand Tetons.
While this year’s topic is: “Reassessing Constraints on the Economy and Policy” there is little doubt that there will be a lot of folks wanting Jerome Powell to come out and define in detail when, if and how he might reassess his reassessment of policy, i.e., his Fed’s stance on monetary tightening.
On one hand, slipping in some guidance at Jackson hole would be a lot safer for Powell than committing to comments to policy after a FOMC press conference.
But on the other hand, it’s unlikely to happen.
Typically, the Fed Chair makes some opening remarks on the first day and that’s followed by a couple of days of paper presentations and (mostly) interesting panel discussions.
But the more informative part of Jackson Hole is what happens between the formal proceedings and during the outdoor breakout press interviews. These are unscripted.
And we know from past press conferences that unscripted responding to the press is not his strong suit. So, it’s probably going to be during those less formal interludes that investors will be hunting for a clue to judge the size of September’s rate hike as well as Powell’s forward trajectory for monetary interference.
Only problem with that is that the size of the September rate hike is going to be data dependent and there will be wagon train loads of new data between Jackson Hole and the September FOMC meeting.
And based on that, Jackson Hole might end up being boring, sterile and uneventful 🤔.
Nonetheless, and while we can remain hopeful for some theatre, here’s a refresher on where things are at so you can tell whether what falls out of the Fed’s saddle bags is something, or nothing.
The economic backdrop to this year’s symposium
The Fed is well into its program of lifting official interest rates, currently in the range of 2.25% to 2.5%. IT’s also started to make the smallest of dents in the balance sheet as it withdraws over-exigent liquidity - less than $100 billion so far.
On the other side of the bet is the bond market which is pricing in a Powell Pivot, which is to say it believes that inflation has peaked (or that the world cannot withstand the sort of tightening that Powell wants to do) and that the Fed will soon be forced to pause interest rate hikes and/or leave the balance sheet where it is.
And with inflation seemingly rolling over in July there is a view that July’s slightly lower print of 8.5% might mean that inflation has peaked.
But San Francisco Federal Reserve president Mary Daly says that the fall in inflation from 9.1% to 8.5% is only a brief respite and that rates will continue to go up with either 0.5% or 0.75% increase the likely range.
So we have opposing forces with the Fed most definitely hawkish, and secondary markets snapping back and playing chicken with Powell’s Pendulums.
Powell’s Pendulums - wait, what are they?
A Pendulum swings to either side of a central point until gravity finally brings it back to the middle.
In our case, the central point is stable prices with 2% inflation plus full employment. The swings outside of centre are interest rate hikes and the balance sheet run off on one side, and secondary market feedback on the other.
While it might be possible to measure how far from centre an interest rate hike might take the economic pendulum (using effect on GDP for example) it is far more difficult to assess what each $100 billion of balance sheet run-off (liquidity withdrawal) will do to the economy.
And when you line up several pendulums in a row and then pull one back and let it go, the force of the first swinging pendulum transmits through the row of balls and results in the final pendulum springing into action.
In our case that final pendulum represents the bond market, and after that ball is propelled to the right, it swings back to the left transmitting a force back the other way, like a reverse feedback loop to the Fed.
So if the Fed puts too much force on the first pendulum, it gets a forceful pushback - and the middle Pendulums (in our case, equities, property, commodities, currencies and crypto) can be struck with unintended consequences.
And that’s what we’ve been seeing since the beginning of interest rate hikes,
Powell’s Pendulums have been a case of putting a lot of force on the first silver ball to crack inflation - and the markets have been feeding back what they think about those efforts, with lower than expected bond yields.
It means that so far, markets don’t believe Powell will be able to raise rates as high as what Powell is indicating - or that they are looking through the guidance to the other side.
Essentially, they are playing chicken with his Pendulums, and hoping not to get crushed on the backswing. They’re pricing in less tightening and inverting the yield curve from the centre which implies they think he will break something by overtightening, thereby forcing the economy into recession.
As per the chart below, U.S. bond yield curves reveal that all maturities from the 6 month to the 7 year government bond are inverted on the 10 year, a sign the market thinks Powell’s Pendulums may cause too many unintended consequences and that there is a big risk of Powell overtightening into a recession.
Note the material flattening of the front end in the chart below from June (dark blue curve) to July (green curve) with most curves inverting at a point between the 2 and 3 year maturities.
And the Fed has not helped matters.
It’s guidance and predictions have whipsawed on inflation for some time now and in June, it predicted and published its view of a neutral rate of 2.5% for 2024 onwards.
June economic projections Dot Plot, extracted from Federal Reserve Press Conference on 15 June 2022.
A neutral interest rate (i.e., the interbank cost of capital that is neither expansionary nor contractionary on the economy) of 2.5% is very low in the scheme of things and not that far away.
It’s low level is more than likely to be the key factor which lit the July equities rally and caused the biggest inversion of short terms yield curves on the 10 year curve. And with gains in equities (and crypto) comes profit taking and spending. Not what the Fed wants. It’s trying to remover demand, not stoke it.
It’s the force on the first and last pendulums that’s important
And there’s something else that represents a reverse transmission force back along the row of silver Pendulums - it’s the massive question of how high a cost of capital a $300 trillion indebted world can stand (where the USD is the reserve currency).
The jury is out on that one - its uncharted territory. But this question adds to the force at which the final pendulum is hitting back each time Powell swings the first one into action.
Also, with a very strong USD, there is a further risk to the Fed that the USD will become an even stronger wrecking ball than it has been, punishing countries that have to purchase very expensive dollars with weak currencies to repay fixed payment dollar denominated debt, and to buy more expensive finished goods.
Another reverse feedback force on the final pendulum hitting back at the Fed is the dollar euro relationship. It’s something sure to be mentioned more than once at Jackson Hole, and we might see an extension to swap lines come out of it, particularly if emerging market bankers corner Powell at the buffet table.
Attribution: Investing.com
The bond market seems to be saying that a fair bit of liquidity is going to have to stay in markets. That’s why it’s hitting back with force.
And it’s not far wrong because the last time the Fed tried to run off its balance sheet it was only able to manage a run-off of $600 billion and four tiny interest rate hikes before both initiatives were scrapped, the balance sheet grew again, and interest rates were smacked back down to zero. Epic Fail.
And, at that time the Fed balance sheet was only half its current size, and global debt was only $169 trillion and the US dollar was not acting like a wrecking ball.
Today global debt is probably around $300 trillion and more debt needs to be created to service it and roll/refinance it over the long term, and still more is needed to fund ongoing global deficits (and potentially more USD currency swaps).
The balance sheet is still a huuuuge force and as of last week weighed in at $8.8 trillion, just ~$100 billion below its peak of $8.9 trillion.
The world needs liquidity and each time the final pendulum snaps back against the previous, it’s a reminder to the Fed that liquidity is required to service and fuel our highly indebted world.
Watch the trajectory and force of the final pendulum, it’s saying something
Biden wants to spend more on woke and with mid-terms coming up in November is still highly motivated to eradicate >2% inflation, and that means Powell (who wants to keep his job) needs to keep tightening, at least for now.
Any sign of a pause will reignite demand.
September FOMC is still a month’s ride from here and there’s a lot of data (including earnings) to come out between now and then, so Powell has got a great excuse to evade the topic at Jackson Hole - given his Fed is now data dependent.
I’m guessing Powell will most likely fall back to his stable prices and maximum employment mandates and continue with a hawkish tone preferring to avoid the subject, and not wanting to cause another rally.
Even so, his problem is that markets don’t believe him. His Fed has lost a lot of credibility lately. And the last Pendulum is snapping back hard as the bond market expresses disbelief.
Simply put, the U.S. bond market is not pricing in rates that go anywhere near to rewarding bond buyers for inflation; and the yield curve continues to invert into an economic contraction, or perhaps a recession.
The market’s playing chicken with Powell’s Pendulums and trying not to get crushed and barbequed on the backswing.
In the meantime, let’s see what if anything emerges from Jackson Hole 2022. Yeeha!
Mike
Image: Conny Querales
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