When The Fed Sells, They Will Have To Get In Line
On Wednesday the Housing Starts and Industrial Production data both seemed slightly better than expected, continuing the February trend of blunting the signs of weakness we had seen in January. As I noted yesterday, these improvements still don’t rise to the level of actually being good, but the market is pleased with less-bad. Stocks rallied 0.4%, while the 10y note contract fell sharply, by 20.5 ticks, to end up clinging (somewhat unconvincingly) to recent support (see Chart, source Barchart.com).
The prospect for higher rates sooner rather than later is growing.
Bonds also were pressured by the extent of the discussion in the FOMC minutes about the methods the Fed is considering employing when it chooses to shrink its balance sheet and drain reserves from the market. This should not be very mysterious, since Fed officials have been speaking quite openly about how they may propose to do this – I wrote something back in December describing Brian Sack’s outstanding speech to the Money Marketeers on this subject (Mr. Sack heads the Open Market Desk at the NY Fed; my thorough discussion of that speech may be found here).
However, every time the headlines hit about the “eventual withdrawal of policy accommodation,” the market seems to think it’s a hint that such a withdrawal may be soon (clearly, the Fed is trying to get the market used to the idea so that it isn’t such a shock when it happens; the market’s insistence on reacting to such headlines indicate they have more preparation to do so I wouldn’t expect those headlines to stop!). I really don’t think that a significant withdrawal of that accommodation will occur for some time, for several reasons. I discuss several of them in that column I just referenced and they are still valid, but I think one of the biggest is that I have no idea who might want to buy the assets they want to sell. As a reminder, one of the reasons the Treasury was able to sell the huge amount of debt they dumped on the market last year was that the Fed bought some $300bln of it and indirectly caused a bunch more buying when they Hoovered up better than a trillion dollars of MBS. It will be hard enough for Treasury to sell the greater supply they need to sell this year without the Fed’s complicity; they certainly don’t need the competition of the Fed selling bonds too.
(A more interesting technical reason may be that the Fed will likely have to realize a loss on securities that they sell which they otherwise don’t mark-to-market, as they likely will have losses on at least some of the portfolio simply by virtue of buying a trillion and then selling a trillion. If I was a market-marker and had to bet which securities would be sold first, by the way, I would look to see on which tranches the Fed is showing a profit).
I expect the FOMC will push up rates at some point, fairly gradually; I will be surprised if they reduce their balance sheet in any meaningful way soon. But all of this helps to put more weight on the bond market. I expect we may see a pretty decent move to higher rates by summer.
On Thursday, economic data kicks off with Initial Claims (Consensus: unchanged at 440k), which fell a large amount last week after several weeks in which it had been trending higher rather than lower. The consensus call tells you that economists think the rise in Claims in January was entirely technical, although I am not so sure.
Also out at 8:30 EST is the Producer Price Index (Consensus: +0.8%/+0.1% ex-food-and-energy). As an inflation guy, I am generally unexcited by the PPI and tend to ignore it.
Economists expect the Philadelphia Fed Index at 10:00 (Consensus: 17.0 from 15.2) will extend the general trend-like bounce from the lows. This is another index that pulled back in Janaury, and the sanguinity of economists in projecting all of these trend-continuations from pre-January numbers is impressive. Consider me still skeptical – I think much of the recent improvement is from “all heck breaking loose” to “average recession levels,” and the real question is whether the economy can take the next step up.
Finally, the Treasury tomorrow will announce 2y, 5y, and 7y Treasury auctions and (ta-da!) the new 30y TIPS auction. How exciting! I continue to think the Treasury should go the extra mile and issue an inflation-linked perpetuity, but 30 years isn’t bad. Keep hope alive!
