The big news this month was the Fed announcement that the Central Bank intends to reduce their holdings of ETF’s and individual corporate notes.  Selling secondary holdings can technically be defined as tightening, but in this case the size is tiny relative to their buying operations and can be explained away as an administrative adjustment.  In individual corporate names they hold over 1,200 line items and about two dozen ETF’s, both investment grade and High Yield.  We don’t expect the unwind to have any market impact at all.  The bigger issue is that the Street has begun to speculate that at the June 16 FOMC meeting, the Fed will raise the rate paid on Reverse Repo and IOER by 5 basis points.  In doing so, the Fed would effectively reset the T-Bill to about that same level, lifting it off of the 0.00% level at which it has been trading for months.  The one issue potentially keeping the Fed from acting is their continued insistence on avoiding any form of tightening – perceived or real.

However, the voices calling for a change of policy are growing louder and include former Fed Governors Dudley and Kohn, as well as former Treasury Secretary Larry Summers.  The basis for the Fed’s reluctance to adjust policy is their stated belief that inflation will be transitory and not permanent.  To be fair, that has been their stated policy for months in anticipation that once the economy returned to full growth, that mandate would allow them to permit the economy to run hot for a period.  But with inflation rising across all sectors, public perception is that rising prices need to be controlled and the Fed is really the only entity capable of doing that.

Evidence of inflation was again evident in the May Consumer Price Index (CPI) report.  Year-over-year CPI rose 5.0% in the month.  That’s up from the 4.2% reported in April and above the 4.7% consensus expectation.  Paradoxically, interest rates fell on the news.  Under normal circumstances, rising inflation would result in investors selling bonds in anticipation of the Fed raising rates to combat the price rise.  However, investors evidently are taking the Fed at their word to keep the money flowing.

Similarly, the stock market ignored the inflation report and traded higher, with indices posting an all-time record high.

A glaring symptom of the easy money policy is the daily Reverse Repo (RRP) facility that the Fed

provides to sop up excess liquidity.  As explained before, the RRP is effectively overnight government debt that is the credit equivalent of a Treasury Bill.  As of June 14th, the facility has grown to $584 Billion and we expect it to continue to climb as the Fed buys Treasury Notes and Mortgage-backed securities in the secondary market.

The one bit of economic data that was less than expected was the May employment report, as it disappointed for the second month in a row.  Our take is that there is a lot of noise in the “bean counting” and expect that the June report, to be released on July 2nd, will more than offset the previous two month’s misses versus economists’ expectations.   The early expectation is employment will have grown by 750,000 workers.

In and of itself, the uptick in RRP is nothing more than further evidence that the Fed has flooded the system with liquidity.  However, we’ll continue to watch the volume for clues to changes in that liquidity.


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