The stellar nonfarm payroll print for May on Friday triggered a spike in treasury yields and drove the stock market into an even more elevated frenzy of bullish recovery bets. It also added a complicating layer to the Federal Open Market Committee’s discussions at the their two-day meeting starting tomorrow, in turn making Chairman Jerome Powell’s post-meeting policy messaging takeaways that much trickier to navigate.
** The market rally will put renewed pressure on the Fed to bring forward its transition from the current “market function” credit and liquidity policies to a newly prescribed accommodative monetary policy and, in particular, to provide a greater guidance on its intentions with balance sheet policy. A sequencing in monetary policy to eventual yield curve caps may be on the agenda this week, but a consensus is still some way down the road. Indeed, we still think it will be September at the earliest before the FOMC will have enough of a sense of the underlying economic trends and for any formal roll-out of the revised monetary policy playbook at the Zero Lower Bound (see SGH 5/19/20, “Fed: On the Transition to Monetary Policy”).
** That said, we would put better than even odds on either or both the statement and Chairman Powell’s remarks to the press mapping out a middle path of flexibility to scale up on the “as needed” pace of treasury purchases to ensure “market function” that is more broadly defined as deterring a premature steepening of the curve. We still doubt the Committee will want to put a number on that yet, as we think the Committee will want to protect maximum policy space for later in the year when the new playbook is formally unveiled. A steady state of $80 billion a month, keyed off Friday’s nudge down in the daily purchases to $4 billion, would be the likely figure if they do go that route now.
** How far they would be willing to go in the transition to a formal QE target will depend on market pricing behavior in the days before Wednesday afternoon, and on the staff financial conditions projections for the near period ahead. It is also worth keeping in mind that the Fed does not entirely mind some yield steepening over the coming months, nor does it want to jump too quickly to repress a desirable market price discovery for fear of stoking financial excesses. In the meantime, there is plenty of accommodative policy that has been pre-positioned with rates brought to zero, and some $2.2 trillion in asset purchases and counting since the depths of the freefall in March.
** Ironically, for what it is worth, the guidance craved by the market, at least on rates, is likely to come through the backdoor of the quarterly Summary of Economic Projections and the rate dot plot. For all the previous hand wringing over the rate dots – and Powell will again stress to take them with a huge grain of salt due to the inevitably huge confidence bands – this meeting’s rate dot plot will almost certainly be flatlined across the three year forecasting horizon, even if there is a likely smattering of rate increases showing up in the full ranges for 2022. The estimates for the longer run neutral may also drop, further accenting an implicit lower for longer rate guidance.
** That takeaway will likewise be reinforced by a more somber read on the near economic outlook. With the caveat the SEPs may not necessarily follow the same format – they probably will but so many Fed officials have been stressing broad scenarios rather than point forecasts that you have to wonder — it seems likely the median year-end 2020 trend growth projection will be sharply negative, anywhere from -5% or worse, with a headline unemployment rate between 10%-12%. Getting back to trend, or where the economy was in February this year, will we think in the Fed projections only come some time towards the end of 2021 or early 2022, and that would assume no more negative shocks.
** Pandemics always come to an end, and our sense before black-out was that many Fed forecasters were already beginning to put less weight on a second or third wave grinding stop to economic activity. But there remain second and third derivative effects of powerful structural changes still to work their way through, be it shuttered businesses, the aftershocks of missed or defaulted lease and rent payments, lower capacity due to social distancing, a higher propensity to save, or firms struggling to reduce cost structures by cutting jobs and wages. It is fair to say at least it is less bad than the darkest fears in the depths of March, but the economy is still in a deep hole, and a long fragile climb remains.
** On that note, while the NFP will provide Powell with the background mood music to offer an upbeat tone in the presser, we think he will still stress the need for continued fiscal largesse – especially against the mounting evidence of a higher fiscal multiplier when monetary policy is stuck at the zero lower bound. Even if he sticks to the script of shying away from specific pronouncements on fiscal policy as Congress battles over the timing and scale of the “Phase IV” fiscal package, Powell is likely to stress it is safer and easier to scale back if the economy rebounds more quickly than expected than it is to open the taps again with a start-stop policy approach. There may not be a second bite of the apple.