Powell finished what he started at Jackson Hole

On 21 September, Fed Chair Jerome Powell addressed monetary policy after the highly anticipated September meeting of the Federal Reserve’s Federal Open Market Committee.

The market was expecting a rise of somewhere between 0.75% to 1% in the Federal Funds Rate (FFR).

Powell delivered the lower end at 0.75% giving a new FFR range of 3% to 3.5% and emphatically stated that he anticipates ongoing increases to a level that will be sufficiently restrictive.

On the topic of QT, or removing market reserves/liquidity by running off the Fed’s balance sheet, he’s not even thinking about thinking about adjustments.

He also said that he’s not interested in thinking about changes to the mortgaged backed securities run-off even in light of decreasing homes values and increasing mortgage costs.

Powell says he wants inflation behind him. He says he wishes there was a painless way to do it, but there isn’t.

Rates will be hiked to exert meaningful downward pressure on inflation because supply chains are not healing fast enough. What’s more is that he’s more than happy to bite the bullet and tolerate an increase in unemployment (even though it will be workers tolerating that kind of pain) so he can complete his 2% inflation objective.

On one hand, good luck Mr. Powell. But on the other, the regime has changed.

And the best question asked at the press conference: how will he know (or will he know) if he has gone too far?

Powell says it’s hard to hypothetically deal with that question, and that his focus is on throttling up interest rates to get inflation back down to 2%.

But I’d remind you all what happened in 1929 after rates, which were already at 5%, were rapidly increased by the final 1% straw that broke the 6% camel’s back (doubling in less than a year) - and the rest you don’t need to be reminded about.

Today, we’ve more than tripled official rates in half the time with bond markets only now reacting, and the world has never been more indebted.

It’s brutal and quick, and Powell has again forgotten the lessons of 1929 - he’s started far too late to normalise this quickly and should have resisted Trump and got his Volcker funk on sooner - but that’s another story I’ve written a lot about for years.

While we can speculate that he will overtighten), what we do know for sure is that the USD will strengthen further (and it’s already doing just that) and the hardening U.S. dollar will transmit more pain outside the U.S.

This is because other countries are forced to exchange more of their own weaker currencies to buy omnipotent USDs to repay, trade, settle, invest, etc, or defend their own currency (more on that below).

It also means commodities will become more expensive for those buyers, and as enough of them feel enough pain, demand for commodities will further decrease, resulting in lower commodity prices.

As I’ve written before, this is premeditated, systematic, demand destruction in an attempt to bring down commodity, food, fuel, transport and shelter prices, amongst others.

And it’s also why we haven’t yet seen any extension to USD swap lines yet to alleviate the pain - it’s not yet painful enough, in Powell’s view.

Today, I wonder if other countries will be expected to catch up to the U.S. tightening schedule, or whether additional USD swap lines will be extended to alleviate the demand for the dollar?

I think the latter is way more likely (and will spell the start of dollar dénouement and the next commodity price upcycle), but that very important act is yet to play out.

Check out the AUD today, it now has a 0.63 handle, and counting.

A Gatling gun of guidance came out during the press conference

Apart from his usual scripted narrative, there were five things I found instructive from the press conference after his speech.

• Policy rates and conditions not yet restrictive

First, the new rate level of 3% to 3.5% is in Powell’s opinion the lowest level of what might be considered restrictive. This was the sledgehammer for equities. Interest rates are like a stake in the heart for equities and Powell is nowhere near done.

So, the takeaway here is to expect restrictive and tighter monetary conditions for longer and well into next year. The ripple effect is that as profits decrease from demand shocks, the cost of capital also increases. Recession begins and that’s net negative for equities.

If he gets to 4% plus buy end of year, then a lot of risk averse people will re-park money in riskless money market accounts, which will be negative for equities.

Whether all of the pain is factored in yet and whether equities has found a bottom is unclear, although I doubt it.

• Unhealed supply side and Ukraine are the drivers

Second, on the question of why he is frontloading rate hikes (i.e., bigger FFR hikes, earlier on) even in the face of potentially overdoing it, Powell says that the Fed has not yet seen the supply side healing that was expected.

So, the so-called frontloading is a sledgehammer reaction directed at destroying aggregate demand and make up for slowly repairing supply chains.

The take home is that because he can’t control supply side, he needs to destroy enough demand to bring demand and supply into balance, at a lower price point.

He is attempting this with fast and furious rate hikes, until he stops. No one knows when, and the Fed keeps on revising its estimate, which brings me onto the third point.

• The Fed is always way behind, always……

Third, the median expectation amongst FOMC members for the FFR increased a full 100 basis points (1%) since the June forecasts.

Below (in my attempted sharpie attack) I have added the June dots, and apologies to the Fed for the defacement of its SEP chart.

Unlike in June, all FOMC members now feel the FFR this year and next year will need to be higher by an additional percent, and the so-called neutral or terminal rate will be well above the 2% watermark, and I’d guestimate it to be 2.6%.

Take home is that the Fed is nervous that inflation is more baked in than it first thought, and that it has not been doing enough to reign it in, hence more frontloading.

And then no rate cuts until 2024- and that was the second stake in the heart for equities. Ouch.

• Finishing the job, he started at Jackson Hole

Fourth, Powell’s resolve to see it through was restated and underscored with a shower of well scripted bullets during his initial speech.

I think this is because the bond market’s response to his Jackson Hole speech was one of lukewarm amusement and tail flicking. And you might recall the reaction was a measly plus or minus 4 to 7 basis points at either end of the U.S. treasury yield curve.

While he blasted the equity saloon at Jackson Hole, his minders probably told him to go and shoot it up some more, and to drop a couple of grenades by the water trough outside the bank to wake up the drunks inside.

Key point here is that the new tighter for longer regime is in and if the bond market wants to bet against the Fed and still price in a pivot for this year, it will need to be prepared to swallow a heap of manure this year as yields continue up.

But it looks like the bond market has woken.

Plus, if Japan sells U.S. treasuries at large volumes to raise money to buy more Yen (to defend it after cratering it though its crazy yield curve control mechanism) that will also push up U.S. treasury yields.

This as well as other second derivative risks to an overtightening may start moving closer into view.

I wonder if other countries will follow suit? And if they do, will they too sell their holdings of U.S. treasuries to fund their own currency support programs and in turn, put more upwards pressure on U.S. treasury yields and exacerbate the USD wrecking ball?

Only time will tell.

• Should the terminal/neutral rate be set higher?

Fifth, during the press conference, Craig Torres from Bloomberg suggested the economy was more resilient, and that perhaps the Fed might need a higher terminal rate, which as we know from the dot plot is still at 2.5%.

In response, Powell said that his Fed thinks the long-term growth trend is about 1.8% but at the same time he and his colleagues are guessing growth will be well below that: 0.2% this year and 1.2% next year.

He also admitted he could be wrong, and that growth could be stronger. Some hedging going on there.

Importantly, he did not answer whether the terminal rate should be higher. There’s a shock.

Take home for me was that if we assume the Fed holds its neutral rate where it is, and supply chains do not repair quickly, and Russia escalates its war in Ukraine and China lashes out at Taiwan and chip supply lines are fundamentally taken out of the market - the Fed’s dot plot will invert.

Wait, What?

What I mean is that if the front-end plots increase again (like they did in the sharpie chart above) it will imply that the Fed’s view of the FFR is still way too low and outside the realms of credibility - and the Fed will need to revise it up or lose all credibility.

For the moment, the Fed is assuming it will be able to destroy enough demand on its current trajectory and clearly did not see the need to adjust its terminal/neutral rate forecast.

Only time will tell.

Bye bye pivot and hello (eventually, but not yet) USD swap lines

Bye bye pivot, for now. Hello high U.S. mortgage rates, declining savings, and a U.S. recession.

And then, when we get to the top of the rate cycle and a big swinging U.S. dollar wrecking ball is doing its worst to destroy demand outside the U.S., Powell will need to decide whether he broadens USD swap lines to lessen dollar impact on weaker economies.

So yes, swap lines are going to be a global game changer.

Swap lines can be thought of as a backstop liquidity facility to stabilise offshore dollar funding markets when USDs are strong and scarce.

I wrote about this in March and July 2020 after Powell extended USD swap lines to ease strains in global dollar funding markets post-COVID.

To an extent these mitigated the effect of those strains, but that was at a much lower cost of capital - like ZERO!

Then, a little over a year ago in June 2021, the Fed announced an extension to those U.S. dollar liquidity swap lines with nine central banks, namely:

• $60 billion each for the Reserve Bank of Australia, the Banco Central do Brasil, the Bank of Korea, the Banco de México, the Monetary Authority of Singapore, and the Sveriges Riksbank (Sweden); and

• $30 billion each for the Danmarks Nationalbank (Denmark), the Norges Bank (Norway), and the Reserve Bank of New Zealand.

Swap lines might need to be extended if the gap in U.S. yields versus other countries widens much further.

Question: Will other countries be expected to catch up to the U.S. tightening schedule, or will additional USD swap lines be extended to alleviate the demand for the dollar?

I think the latter is way more likely (and will spell the start of the dollar dénouement and the next commodity price upcycle), but that very important act is yet to play out.

Until that happens, what does it mean for us here in WA, today?

In the U.S., we can expect tighter conditions and weaker (certain) commodity prices for longer. Bye bye Powell pivot for now (unless he’s told to) but don’t take your books because you’ll be back and maybe, when we’re least expecting once swap lines have been extended.

Here, the Reserve Bank of Australia (RBA) may or may not play catch up if U.S. treasury yields continue to moon, which in turn will cause the U.S. treasury and Aussie bond yield spread to widen.

But it may not need to because the Aussie bond market has already reacted and pushed up yields way above official rates without too much pushback. In fact, out bond market put the RBA in its place when it rallied against the RBA’s attempt at yield curve control - which blew up in the bank’s face. Suspect they won’t do the Darryl on that one again.

While there’s been a lot of speculation here that Governor Lowe might be at, or close to his high, we just don’t know.

But if the spread does widen, the USD will strengthen even further against the AUD and we’re already at an 0.63 handle today, and probably going lower still.

And, if the RBA does not raise rates, will it intervene in the currency market? Don’t know.

And if it does, what will it issue or sell to fund that, and at what rates?

China continues to weaken. China weakness also embeds weakness in the AUD. An escalation of China versus Taiwan will also upset the currency pair, should it happen.

So, we have a multi-whammy that’s creating a weaker AUD against the greenback, and that means more money for WA exporters when converting USD proceeds to AUD (which unfortunately will only partially cushion commodity price decreases), and less money for importers as they use more AUD to import things in USD.

The RBA seems to be in a predicament.

Australian exporters of coal, some gas, some decarbonisation/green minerals and metals, and certain food groups will continue to see demand, but not under all scenarios. There will be some pressure on prices even in these Rockstar mineral markets. Perhaps thermal coal and lithium will be the last shoes to fall?

More generally, and while long term demand is strong due to underinvestment, war, woke, and unhealed supply chains, short term demand could become more volatile, and we’re already seeing the early stages of a midwinter spring cycle before spring returns.

And it’s not exactly intact elsewhere. Financing for many other non-mining related industries (and juniors in almost all industries) will become tricky and difficult.

Equity providers and lenders will become more discerning as forward earnings and cash flows come under the microscope in a world that no longer has a zero cost of capital.

Some debt zombies will fail. Others will be refinanced and propped.

It also means that companies will turn more and more to inorganic strategies like mergers, acquisitions and divestments for proactive defensive purposes or out of desperation (the weak ones) or to opportunistically grow and reshape their competitive landscape (the stronger ones).

Non-differentiated and loss making growth companies are likely to see a larger next leg down.

Good M&A in the coming market will be that which allows the combined business to better defend against, or respond to the headwinds, and/or latch onto the tailwinds mentioned above.

Businesses that can capture the benefits of tighter for longer in the U.S., i.e. USD strength/AUD weakness, higher costs of capital/interest rates, and energy shortages/transition, could do well.

Those that can’t need to make some moves so that they can. Simples.

Mike