Financial markets have reacted positively to recent statements from Federal Reserve Chairman Jerome Powell and the Federal Open Market Committee (FOMC). Following Powell's comments, stocks experienced a boost, continuing their strong performance from earlier sessions. Yet, there was a slight cooling of enthusiasm by the end of the trading day.
Meanwhile, Treasury yields witnessed a decline; two-year notes dropped by three basis points, while ten-year notes fell by one basis point. This phenomenon raises an important question: was the FOMC's stance a dovish one or not? Not necessarily. It's easy to envision a scenario where investors could have listened to the Fed's remarks without being pleased at all.
Indeed, the committee has made notable adjustments to its economic outlook, lowering growth forecasts while slightly increasing expectations for unemployment and inflation. These changes reflect an economic term often described as stagflation, which is a concerning scenario combining stagnation and inflation.
Although the Fed isn't predicting a significant stagflation scenario, indicators suggest a troubling trend, as both economic growth and inflation forecasts have veered in unfavorable directions. Powell elaborated on the reasons for this shift, attributing it largely to a steep decline in investor, corporate, and consumer confidence, greatly influenced by concerns surrounding Trump's policies, particularly tariffs.
It’s important to acknowledge that the Fed's interest rate projections remained unchanged in the average; however, this average conceals a significant shift toward a more hawkish monetary policy. Excluding the highest and lowest three individual estimates, forecasts for the 'core rate' of monetary policy have shifted upward from a range of 3.6% to 4.1% to a new range of 3.9% to 4.4%.
During the recent press conference, Powell underscored the rising uncertainty among committee members regarding their economic projections. He characterized this uncertainty as not only high but also imbalanced, heavily favoring predictions of slower growth and higher inflation.
Despite these unsettling indicators, one may wonder why financial markets responded so calmly. Several explanations can be put forth: initially, the Fed conveyed a message that markets had already absorbed. Investors appeared to have anticipated that political uncertainties had heightened the risks of slowing growth and rising inflation.
Investors were also reassured by the Fed's lack of a hardline stance against inflation risks related to tariffs. Powell's balanced rhetoric offered some comfort, emphasizing that inflation spikes driven by tariffs could be managed, provided long-term inflation expectations remained controlled. This approach illustrates a central bank that is opting to avoid direct confrontation with the executive branch.
Additionally, markets just eager for some positive news after a turbulent month chose to focus on the unchanged interest rate forecasts, disregarding other alarming indicators. In a surprising move, the Federal Reserve announced a significant slowdown in the pace of quantitative tightening, reducing the cap on securities that can leave its balance sheet from $25 billion a month to only $5 billion. Given most indicators, this tapering of quantitative easing was not entirely unexpected, especially considering that many projections at the end of last year pointed towards a mid-year end to quantitative tightening, likely by June.
However, the situation has changed, as recent minutes from the FOMC's January meeting indicated that central bank officials were exploring the option of terminating quantitative tightening earlier than planned if there were fluctuations in reserves tied to looming debt ceiling dynamics.
Analysts, including those we consulted before the meeting, believed that any gradual ending of quantitative tightening would commence in May rather than in March. Powell emphasized that the decision to decelerate quantitative tightening is part of a natural progression and does not signal concern about the debt ceiling, despite differing messages from January's meeting minutes.
As this year began, the debt ceiling—the cap on how much the U.S. can borrow to finance its ongoing deficit—was reinstated after a two-year suspension. Until the ceiling is raised or suspended again, the U.S. Treasury cannot issue new net debt, effectively draining its fund of $414 billion at the Federal Reserve. Time is critical; even with new tax revenue, the Treasury is expected to exhaust its funds "at some point this summer, perhaps in August," according to Brea Khurana of Wellington Management.
By then, the Treasury will need to resort to exceptional measures to protect the U.S. government from defaulting on its obligations. It's likely that Congress will raise the debt ceiling before reaching that critical point, though political maneuvering is certainly expected, and afterward, the Treasury will need to issue new debt in order to replenish its financial coffers.
Guneet Dingra, chief U.S. interest rate strategist at BNP Paribas, warned that if this coincides with continued quantitative tightening, it would lead to a double squeeze on the liquidity of the financial system, something the Fed aims to avoid. He remarked, “As the Treasury drains its cash balance, it injects additional liquidity into the banking system. However, as the Treasury replenishes its cash balance through new bond issuances, those funds shift from the banking system back to the Treasury’s account at the Fed, withdrawing liquidity from the banking sector.”
Simultaneously, quantitative tightening also reduces liquidity. The Treasury issued new debt in 2022 when quantitative tightening was in full swing, but at that time, there was still greater liquidity and varied sources available, such as funds in reverse repurchase programs.
If a significant overlap occurs between quantitative tightening and a surge in new Treasury bond issuances, a sharp liquidity crisis could arise, affecting the stability of the financial system.
The slowdown in quantitative tightening is welcome news in financial markets, with stocks poised to benefit from the anticipated extra liquidity. Although the impact of tightening and easing policies on Treasury yields might be limited, the conclusion of quantitative tightening should yield a slight decrease in these yields, all other factors being equal.
In our assessment, we tend to believe Powell's statements; however, the slowdown in quantitative tightening will undoubtedly relieve some pressure during a summer likely to be marked by political and financial tensions.
Some Republican members are focusing on the national debt issue, while many Democrats seek to find ways to counter Trump’s policies, raising the chances of financial clashes as Congress weighs how to address the debt ceiling.
In this climate, it may be wise to reduce potential risks wherever possible.
