Market turmoil has reached a fevered pitch as investors continue to digest the May inflation reports. Headline year-over-year CPI for May came in at 8.6% versus the consensus estimate of 8.3%, and the ex-food and energy tally came in at 6.0%, a touch above the survey estimate of 5.9%. Contributing to the unease was the University of Michigan survey, a popular coincident indicator of consumer sentiment. The overall sentiment tally plunged to 50 versus 58 last month, and the inflation expectation component for the coming year ticked up to 5.4%. That’s a clear message to Messer’s Biden and Powell of no confidence in their inflation fighting prowess. The market rection to the news has been brutal, with the 2-year Treasury note trading as high as high as 3.43%. Similarly, the S&P 500 is now 22% off the January high.
Reacting to the harsh criticism, the Federal Reserve raised the overnight Fed Funds rate by 75 basis points at the June meeting, taking the rate corridor to 1.50% to 1.75%. Moreover, the Central Bank is forecasting the overnight rate will rise to 3.4% by the end of this year. With that hawkish statement, it seems likely that they’ll raise the overnight rate another 75 basis points at their July meeting. With no meeting scheduled in August, the Fed will have an opportunity to evaluate the four rate hikes engineered so far this year. We caution, however, that monetary policy works with a significant lag and there’s no reason to expect that it’s any different this time around. The rule of thumb is it takes 14 months for a rate move to affect economic activity.
The vote was not unanimous as the Kansas City Fed President George dissented and voted for a 50 basis point hike. There was no immediate explanation for the dissent, but it will probably be revealed at her next public speech.
Equally important to monetary policy, but less headline-worthy, the Fed began to reduce their balance sheet, referred to as the System Open Market Account (SOMA) portfolio, this month. The intention is to gradually expand the operation into September with the monthly runoff of $60 billion per month in Treasury Securities and $35 Billion agency MBS. The cap would be reached from a mix of coupon payments and a runoff of T-Bills.
To put the operation into historical context, the Fed last began their first SOMA runoff in 2017 and continued into 2019. Once fully ramped up, the reinvestment of principal and interest was capped at $30 billion Treasury securities per month, and $20 Billion Agency MBS per month, so the current incarnation is nearly twice as large. Inflation remained anchored around 2% during the operation, but the YTM of the 2-year Treasury note rose from approximately 1% to 2.9%. The Fed had raised rates from 0.25% to 2.5% over the period. The Fed stopped raising rates at the 12/2018 meeting and concluded in the runoff in August 2019 as GDP growth slowed.
The agency MBS runoff would likely fall under the $35 billion monthly cap due to the dramatic slowdown in prepayments. The committee has communicated that they will consider outright sales in the future, but that remains an open decision. It was also communicated that any program sales would be announced well in advance. The impact the runoff will have on the market has not been widely discussed, but the impact on rates from the 2017-2019 operation should not be overlooked.
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