PGIM Fixed Income: Weekly View from the Desk
Views on FOMC Projections, Rate Liftoff
The rollout of the COVID-19 vaccines at the turn of the year shifted the narrative of the U.S. economic recovery from “when” to “how strong.” Shortly thereafter, we began anticipating that the Federal Reserve might begin tapering its asset purchases by the end of 2021, which remains our base case looking ahead. This post discusses our rationale for this projected timeline, the new problems now emerging as the Fed continues its large-scale asset purchases, and how this reduction may differ from 2013’s taper tantrum.
In the spring of 2020, when the COVID-19 crisis triggered a sudden-stop in economic activity and mad dash for cash in financial markets, the Fed responded quickly, opening the playbook it had developed 12 years earlier during the Financial Crisis. In short order, it dropped the Fed funds rate to zero—signaling it would be kept low-for-long—launched QE purchases of Treasuries and agency MBS, and added credit and liquidity programs designed to backstop other credit markets and to complement the massive fiscal support being deployed. The enormous, rapid fiscal and monetary responses to the crisis appeared to meet their objective—they provided a bridge to help the economy reach the other side of the pandemic.
The path followed by the economy over the past year, however, provides an important reminder that although recessions rhyme—each entails a broad-based decline in activity that is sustained for some period—the trigger(s) and exact contours of each can differ, in some cases dramatically. The recession and recovery from the COVID-19 crisis serve as a case in point. The much sharper-than-expected V-shaped rebound surprised both the Fed and most economic forecasters, yet was front-run by an even stronger, more rapid rebound in risk asset prices.
At this point, U.S. GDP has now rebounded to its pre-COVID level and last year’s feared drop in inflation expectations has reversed itself and then some. Given expected further strong gains in economic activity over coming quarters, we anticipate GDP will grow 6.5% this year. Supply bottlenecks, not insufficient policy stimulus, are the constraining factor at this point. In the labor market, the demand for workers appears to be recovering much faster than the supply, with job openings at record levels, and small businesses citing lack of available workers as a foremost concern. Employment is expected to improve by this fall, though, amidst further progress on vaccinations, additional school reopenings, and expiration of the boosted unemployment benefits in September, with half of the states so far adopting an even earlier end.
Against this backdrop, financial market participants have been ahead of the Fed in discussing an end to its QE purchases. Unlike in the early phases of the crisis 12 years ago, when the Fed devoted significant effort explaining to the public what QE was meant to achieve, comparatively little explanation or justification was required this time around. Market participants understood QE and its implications. And unlike the taper tantrum that ensued when then-Fed Chairman Bernanke broached the topic of tapering in May 2013 (Figure 1), this time, it has been market participants initiating the taper discussion. In recent weeks, though, a number of Fed officials have joined the conversation, indicating it is probably time to put the issue on the table.
Beyond the strength of the economic and financial market recovery to date, several technical factors brewing since early March are likely hastening the tapering discussion. Like much of the private sector, the U.S. Treasury built up a war chest of cash during the pandemic, issuing more Treasury securities than required to fund its current cash needs and depositing the proceeds in its account at the Fed. That extra issuance effectively mopped up the equivalent amount of liquidity from the banking system. But with passage of the $1.9 trillion federal stimulus package in March 2021, the Treasury has been drawing down its balances at the Fed to meet the expenditure requirements in that package, effectively injecting those balances back into the banking system. At the same time, exemptions from Supplementary Leverage Ratio (SLR) capital requirements granted to large banks for their holdings of Treasuries and reserve balances at the Fed during the COVID crisis expired at the end of March 2021. Bank demand for these assets presumably declined given the higher capital requirements.
Consequently, short-term interest rates have become “soggy,” with several portions of the money market now experiencing slightly negative nominal rates and the Fed funds rate trading closer to the bottom of the Fed’s targeted band of 0.0%-0.25%. Use of the Fed’s reverse repo facility, a means for absorbing excess liquidity and helping to put a floor under money market rates, is now seeing a surge in activity (Figure 2).
The Fed is also considering a tweak to its administered rate (interest rate on excess reserves, IOER), as it has done a few times in recent years in order to keep the Fed funds rate closer to the mid-point of its targeted range. Meanwhile, the Fed is buying the lion’s share of net new agency MBS originations—risking the possibility of damaging private market functioning the longer that trend persists. In short, the flood of liquidity that the Fed continues to provide through its QE purchases is now itself requiring policy “fixes.”
What if the forecast for a continued strong recovery proves wrong? While we expect growth to moderate to 4.5% in 2022, next year’s growth slowdown will likely be cushioned by some of the caution displayed to date. Households, government agencies, and state & local governments have not come close to spending all of the fiscal stimulus received. In fact, households have been saving and paying down debt at a record pace, which should support consumption going forward. But if growth and/or inflation surprise to the downside next year, the Fed could ease financial conditions further by signaling the Fed funds rate will likely be kept at zero for even longer than its forward rate guidance now suggests (Figure 3).
Given the strength of the recovery to date and signs that the Fed’s liquidity injections may be becoming excessive, the Fed’s tapering decision appears closer at hand. The Fed will likely want to see at least another quarter of improving economic activity—waiting until Q4 2021 to begin tapering would allow Fed officials to observe whether recovery of the economy, and the labor market in particular, actually make significant further progress. Until then, we anticipate that the ongoing talk about and prior experience with tapering will continue to condition and prepare financial markets for the Fed’s eventual reduction in asset purchases.
This material reflects the views of the author as of June 7, 2021 and is provided for informational or educational purposes only. Source(s) of data (unless otherwise noted): PGIM Fixed Income.
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