Last week, the Fed continued to raise Treasury interest rates by another +25bps, while also not clearly showing its stance on policy for upcoming meetings. However, one thing is certain: the Fed's current policies depend heavily on fluctuations in macroeconomic indicators in the coming period.
In addition, maintaining high interest rates for a long time is not the only pressure on the increasingly rising US Treasury bond yields. The policy to expand the adjustment range of the yield curve (YCC) from the Bank of Japan (BOJ) is also impacting the US bond market.
This week's macroeconomic article from VietHustler will analyze the above events with 2 main questions:
How will macroeconomic data affect the Fed's proactivity in regulating the economy?
Meanwhile, how will the impact of BOJ adjusting the YCC policy put the Fed in a passive position?
New Video: Since last May, the US stock market has continuously rallied with significantly improved liquidity sources. So where does this new money come from when the FED is in the process of tightening policy and retail buying power has gradually depleted? The main answer is the massive reserve of over 2 trillion dollars from the Federal Reserve. So what is Reverse Repo and how has it helped the market rally?
Fed's direction after FOMC July 2023
Highlights from the July 2023 FOMC
3 highlights from the July 2023 FOMC meeting:
Fed continues to raise Treasury interest rates by another +25% (to 5.25 - 5.50%).
This is the 11th time the Fed has raised rates since 03/2023 and it is the highest base interest rate in 22 years (since 01/2001).
Currently, Fed Funds Rate is higher than inflation by +2.4%. The last time monetary policy was tightened like this was back in August 2007.
Powell emphasized that the Fed focuses on Core CPI rather than headline CPI.
Therefore, this rate hike decision had the consensus of all members because the Fed believes inflation is still quite high.
Recall: While headline inflation (CPI) in June 2023 is only +3% y/y, Core CPI is still rising to +4.9% y/y.
The Fed's stance (through Powell's speech) shows that the Fed's steps are cautious - decisions will be based on aggregate economic data.
Powell emphasized that from now until the September meeting, the Fed will closely monitor economic data to make decisions for the FOMC on 09/21.
Among them, the economic data mentioned by the Fed includes: labor reports, CPI reports, and labor cost index (Employment Cost Index - ECI)...
Full Powell speech:
However, the Fed seems to be emphasizing observation of coincident or lagging indicators (indicators that occur simultaneously or reflect the economic situation with a lag).
Below, Viet Hustler will analyze the latest movements of the indicators that the Fed is monitoring.
What do the indicators the Fed is monitoring reflect about the economy?
Price and inflation indicators
Inflation indicators show that inflation is on a downward trajectory based on disinflationary pressures. However, core inflation data is still quite high compared to the Fed's expectations.
Although core CPI growth is still high (+4.9% y/y), the latest 3-month average growth has decreased significantly: confirming the downward trend of core inflation.
(The latest 3-month average is often used to predict changes in the trends of economic indicators.)
The latest PCE (Personal Consumption Expenditures) report last week also shows that demand-side inflation continues to decline.
Headline PCE: +3.0% y/y
Core PCE: +4.1% y/y
PCE monthly growth is only at +2% m/m in June 2023 - the lowest figure in the past 10 months.
In particular, the 3-month average PCE figure also shows the downward direction of PCE, especially super-core PCE services (the stickiest inflation category):
Core goods PCE (3-month average - 3MA): +1.6% y/y
Housing PCE category (3MA): +6.2% y/y
Super-core services PCE (excluding housing costs)(3MA): +3.3% y/y
FYI: PCE is the 'pure' inflation measure based entirely on actual consumer spending. PCE is one of the Fed's favorite inflation indicators because tight monetary policy from the Fed affects the demand side.
Wage and income pressure on inflation (wage-price spiral)
The Employment Cost Index (ECI) is considered by the Fed as the most standard measure of household income growth.
ECI has slowed in Q2/2023: +1.0% q/q (down from Q1/2023: +1.2% q/q), +4.8% y/y shows that pressure from wages (income) on inflation has eased.
However, ECI is still at a 30-year record high (upper right chart) indicating that wage and income growth remains high.
Therefore, the Fed will be somewhat cautious about the ability to contain inflation due to wage growth (wage-push inflation).
Upcoming labor reports will have a significant impact on the Fed's assessment of wage growth and supply-demand balance in the labor market.
Currently, the supply-demand situation in the labor market remains tight:
initial jobless claims continue to decline to just +221,000 last week (lower than the estimated +235,000).
GDP supports the Fed's 'soft-landing' prediction
Powell emphasizes that the Fed no longer sees recession risks for the economy. The Q2/2023 GDP report seems to support this view from the Fed.
GDP growth increased in Q2/2023: +2.4% q/q (higher than forecast +1.8% & Q1: +2%).
Economic growth occurred in almost all major categories including: consumption, non-residential investment, and government spending.
Of which consumption was higher than expected: +1.6% q/q, contributing 68% of economic activity.
Consumption has steadily grown over the past 3 months.
However, the impact of credit crunch remains an unknown. Therefore, Viet Hustler maintains the view that soft-landing is not certain, recession may still come late.
Recession may come late and may originate from debt crises of businesses, households, and government.
The debt shock to businesses and households has not yet arrived
Credit crunch has occurred (figure below):
Both large banks and small banks are facing unusually declining deposits:
deposit growth at negative levels and falling out of the 95% confidence interval (light gray area) - 2 charts above.
Large banks have largely tightened lending: cumulative loan growth fluctuating around 0% (bottom right chart).
But businesses and consumers have not yet truly felt the pressure from credit crunch.
Despite Fed rates rising +525bps over the past more than a year, household debt service costs (% of income) remain lower than pre-Covid-19 levels.
The reason is that most current debt enjoys low interest rates from the QE period, and households also paused student debt payments during Covid.
Businesses have not yet reached the maturity stage of low-rate debts signed during QE, thus debt service costs for businesses remain lower than current market rates.
Coming up in September, households will have to resume student debt payments. Meanwhile, from 2024, some businesses will start seeking refinancing from banks.
Another hypothesis is that the current QT from Fed is not yet thorough because Fed is still injecting money into small banks through lending programs to counter banking crisis (BFPT and Discount Window).
Fed's balance sheet has decreased -USD 100 billion since early March/2023, but net liquidity has increased +USD 134 billion.
Thus, small banks can still continue lending to businesses (though limited), while cumulative loan growth from large banks ~0.
Thus, need to further observe pressure from credit crunch over the next year to determine if soft-landing is truly feasible.
BOJ continues to control the yield curve: impact on US public debt costs
The alarming US public debt issue has been mentioned by Viet Hustler in many articles.
Related articles: US Debt Ceiling: An annual economic puzzle for the US Congress?
In addition, monetary policies from other major Central Banks will also affect US government bond yields in the free market. The Bank of Japan adjusting the yield curve last week is a typical example.
Previously, BOJ implemented yield curve control (YCC) through buying and selling Japanese Government Bonds (JPBs) 10Y, to ensure the yield of this bond stays within +/- 0.5% (increased from +/-0.25% at the end of last year).
Currently, BOJ has increased the YCC band to +/- 1.00%.
FYI: In previous disinflation and deflation periods, YCC was BOJ's way to adjust long-term bond yields, alongside QE.
QE only affects short-term rates in the free market, as QE focuses on the quantity of assets purchased (all types of assets), and only aims to adjust liquidity.
While YCC adjusts 10Y bond yields to fluctuate within a certain range, thereby maintaining long-term rates.
Thus, instead of raising the policy rate like other Central Banks to adjust rates through bank funding costs, BOJ impacts the free market directly through long-term bonds (while keeping the policy rate unchanged - bank funding costs).
From the end of last year to this year, due to rising inflation and tightening monetary policies from other Central Banks, BOJ was forced to increase the yield curve adjustment band to ensure JPY value, retain domestic capital, and mildly curb inflation (as BOJ faces less pressure from price stabilization).
Related articles:
Explanation of Yield Curve Control and why BOJ had to expand YCC during the global inflation period.
Immediately after expanding the YCC limit, Japanese 10Y bond yields surged.
Impact on US bonds:
Japanese investors currently lead in holding large amounts of US Treasuries.
Thus, higher rates in Japan will reduce demand for US bonds.
Japanese investors may sell US bonds to return to buying domestic bonds (also avoiding FX risk).
This causes US bond yields to rise (due to reduced market demand), further increasing the public debt cost burden on the US government.
Additionally, JPY value also rises against USD: => burden on US inflation due to relative decline in USD value.
CONCLUSION
Fed is taking cautious steps in deciding on interest rate and monetary policy: whether to hike or pause hikes is based on market data observations. The economic indicators Powell emphasizes monitoring include: core inflation (CPI), employment reports, and income reports.
Good news is core inflation is on a downward trend and pressure from income growth on price growth (wage-price spiral) is also easing. However, both core inflation (CPI and PCE) and labor costs remain too high for Fed to truly stop hiking rates. From now until the next FOMC, there will be 2 CPI reports and 2 labor reports that Fed closely monitors to decide its policy in September.
In addition, the tight labor market with high hiring demand and low unemployment rate, along with the better-than-expected GDP report, supports the Fed's soft-landing possibility. This could also encourage the Fed to keep interest rates high for longer. However, the impact of credit crunch remains uncertain. Viet Hustler believes it will take at least another 1 year to observe the lagged effects of interest rate policy and credit crunch on economic activities.
Finally, maintaining interest rate policy for a long time will increase pressure from high public debt costs on the US government. Especially as the BOJ has expanded its control on 10-year bond yields to 1%, demand for US bonds will decrease and push up the US government's borrowing costs. In the next 1 year, will the US government, businesses, and people fall into a debt crisis at the same time?
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