Did the Fed Just Give Us Yield Curve Control?

IBKR’s Steve Sosnick, Chief Strategist, and Jose Torres, Senior Economist, sit down for their regular monthly discussion about the economy.  This month’s featured topics are the April Employment Report, the May FOMC meeting, and their takeaways regarding the potential for stagflation and further changes in monetary policy.

Summary – IBKR Podcasts Ep. 157

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Steve Sosnick 

Hi everybody, welcome to the latest edition of IBKR Podcasts. Today I’m your host, Steve Sosnick, Chief Strategist at Interactive Brokers. I’m joined by my colleague, Jose Torres, Senior Economist here at Interactive Brokers. Hi, Jose. 

Jose Torres 

Hi, Steve. Hello everyone. 

Steve Sosnick 

Today, as is customary, we’re doing our monthly economic roundup. We typically do those on the Monday after jobs’ numbers. And last week we had an extra special week because we also had an FOMC meeting that coincided with those job numbers.  

Just as a parenthetical, I find those weeks very interesting because a similar week in February of 2023 was what I like to call the debutante ball for 0DTE. And the reason for that was you had a similar setup with the Fed meeting on Wednesday and jobs’ numbers on Friday. That was, I believe, the first time that the markets went crazy with the use of “disinflation”. I think that was the buzzword that week.  

And people discovered on Thursday, “wait a minute, we can speculate to our hearts’ content and not have to hold options that leave us exposed to the jobs’ numbers on Friday”, which, at that point, actually were a bit of a disappointment and took away probably 1/3 to 1/2 of the two-day gain.  

Sorry for that long winded intro but Jose, as you look at the numbers as an economist, both holistically for the Fed meeting and for the jobs’ numbers, which seemed complementary, what’s your takeaway? 

Jose Torres 

Total jobs added were 175,000, which is typically strong. However, in the months preceding that, we had job growth a lot stronger. From that 175,000, 95,000 were added from one sector, which was private education and healthcare. Wage pressures softened significantly down to 20 bp month over month. Unemployment rate ticked up. 

Collectively, market participants were very happy because the report as a whole showed that labor conditions are softening. Most employers aren’t hiring at a really fast clip, but they’re also not firing. Initial unemployment claims and continuing claims are well behaved.  

Job openings are still well above pre pandemic levels above 8 million. Corporates are in a “wait and see” mode. Last few years we’ve had a lot of stop-and-go kind of economic conditions where we’re thinking the consumer falls off a cliff, then they come, and they pick up their spending right away and then we’re back into an expansion mode.  

Overall, though, alongside the first quarter GDP, this payroll print, especially this concentration in that non-cyclical area of private education and healthcare, is pointing to slower conditions. 

Steve Sosnick 

That kind of leads me into the next phase of it, because Powell gave yet another what I would call “Goldilocks” press conference, where he really pushed back on the idea of rate hikes, which I think was kind of freaking people out a little bit.  

But he also pushed back on the idea of stagflation. And at 10:00am on Friday, after Eastern Time, we received ISM numbers that sort of had another whiff of stagflation.  

Could it be that his dismissiveness of stagflation is maybe because his definition is a bit more real, nasty 70s stagflation orientation rather than just sort of the malaise that we might get with mildly higher prices and mildly stagnating, or just a generally blah economy? 

Jose Torres 

I think that’s a discrepancy there. Folks remember stagflation. They want to see, when they’re thinking about stagflation, negative economic growth and higher inflation than target.  

But the difference here is that we’re seeing that in direction, right? We’re seeing inflation jump from fourth quarter of last year and we’re seeing economic growth slide. So, in direction, we’re headed towards stagflation. But in magnitude, we’re not there yet and I think that’s the difference.  

Economic growth is still positive. Consumers are still spending, albeit savings rates are near the basement. Confidence and sentiment levels have been waning recently, particularly the Conference Board’s figure.  

Overall, there’s risks of stagflation, but I don’t think it’s right around the corner because the consumers’ propensity to save is particularly low, and that’s really going to drive revenue growth and GDP numbers higher overall. 

Steve Sosnick 

The second part would be: did he move the goal posts a little bit when he reminded everybody that we’ve been focused on 1/2 of the Feds dual mandate, the prices part, while sort of ignoring the full employment portion, because quite frankly, we hit the full employment portion? 

Is he sort of premature in refocusing the dual part of the dual mandate, or is that an appropriate move at this point, based on what you saw in some of the job numbers? 

Jose Torres 

When you consider the jobs number, then maybe he’s more justified. But he did say during the conference that they don’t have access to the numbers before we do, right? So, we can’t assume that he knew a soft number was coming, right? 

But let’s rewind a little bit prior to the report. We’ve got inflation data for January, February, March and April incoming. Four months so far this year.  

Not one of those reports, including the one that we haven’t seen yet, is going to show inflation that’s running at the Fed’s 2% target on an annualized basis. This goal post is particularly low because all I’m saying is, “get me to 17 bp month over month. On CPI core, CPI headline, PCE headline, PCI core, whatever you want.” We haven’t gotten there in January, February, March or April. 

Steve Sosnick 

Which also means that as you annualize, there are people who annualize that just sort of take the number multiplied by 12. I believe a lot of economists, I believe including yourself, prefer to annualize the rolling last three months.  

But as you say, if none of those numbers annualize to 2%, where are we? What is your favorite annualization? Because I don’t want to put words in your mouth.  

Jose Torres 

I like three month annualized, but I do like CPI, Steve. And I like CPI more because it really adequately reflects the housing element of Americans’ budget constraints.  

PCE weighs housing at around 20%. CPI weighs housing a lot higher. And that’s actually part of the reason why PPI has been quite loftier than PCE. 

Steve Sosnick 

OK, that’s a very important distinction. And while we’re throwing out acronyms here, one of the important things that I took away from the FOMC statement was that the Fed will be reducing quantitative tightening. So they will be, instead of letting the balance sheet run down by $60 billion each month in treasuries, that number will only be $25 billion, meaning they’re going to reinvest $35 billion in proceeds from maturing treasuries more than they had been.  

Two things came up because I happened to be at an options conference at this point. And so, various people affiliated with the industry were buzzing about this. And two things came up. One person said, “well, isn’t that QE?” I pushed back on her a bit, saying that just because you’re tightening at a slower pace doesn’t mean you’re easing. I’d like your opinion on that, but hold that one sec. 

And the second, which I thought was a more difficult question to wrestle with, and I really want your opinion on this. Is this a way that the Fed can exercise some sort of yield curve control? So, if you could take those up, I’d really appreciate that, Jose.  

Jose Torres 

Absolutely. By lowering the runoff rate, you’re essentially helping out the treasury, right? And that is essentially yield curve control. Not putting as much pressure on the long end of the curve. This is something that you mentioned a lot in your commentaries. And something that sort of disturbs me because the Fed is just so adamant about all this patience they have and “over time” and “as long as we get there”. And the SEP [Summary of Economic Projections] dots show that they’re going to get to 2% in 2026.  

And in 2021, Steve, when they were adding securities to the balance sheet, we already were getting inflation readings that were super strong. Capital markets were buoyant. It was clear that we didn’t need any further monetary stimulus to that degree, which at the time was $120 billion [per month]. And they just kept going and going all the way, if I’m not mistaken, ‘til March of 2022. 

And now we’re in a rush to totally cut more than half of the runoff on the Treasuries side, because we’re getting concerned over bank reserves and reverse repo and liquidity condition. And we’re favoring financial stability and employment. And we’re implicitly accepting inflation at 3% to 3.5%. And that’s what I think is going on.  

Overall, final point here. Gone are the days where monetary policy restrictiveness is based upon one number. “Oh, the Fed funds rate is 5.5% in the upper range. Oh, that’s two percentage points above CPI at 3.5. Wow, that’s restrictive.”  

When you consider everything else they’re doing, whether it’s the dovish rhetoric from the Fed, the speed at which the Central Bank comes in to help when volatility emerges, the balance sheet situation, all those things collectively point to quite a loose monetary policy regime.  

And when you look at financial conditions indices, whether it’s to Bloomberg, the Chicago Fed, Goldman Sachs, all are pointing to looser conditions that really don’t point to slower inflation readings in the next year or two.  

Finally, geopolitics have been improving in the last few weeks. If that continues that way and tensions are kept at bay, that is going to help the Fed with the price pressure objective — albeit I don’t think they’re going to get to 2%.  Not with this kind of loosening in financial conditions. 

Steve Sosnick 

That to me really is the key here. And I think it’s very important for people to keep in mind that, number one, I think your point is crucial. Although the Fed is restrictive, I’m going to call it “restrictive-ish” for the reasons you just described.  

And number two, historically, the Fed’s been forced to look as far back as like the ‘70s, which most investors who are currently active just don’t have a history with. If you would have been active in the late ‘70s, you’re probably of retirement age, whether or not you’re still investing or not.  

So whole generations have grown up not realizing that historically, but even so, like into the ‘90s and early 2000s, that a 5% nominal interest rate and a 2%, give or take, real interest rate is normal, historically.  

The problem is, I think, for 15 years we’ve gotten conditioned to the idea that these numbers need to be somewhere near 0 and they don’t necessarily.  

And I think this is where your point is critical.  It’s that you can be sort of, if not accommodative, only mildly restrictive, or certainly not restrictive to a point where you really are punitive with numbers around here. So just final, lightning round question, would you say the Fed is actually accommodative, restrictive, relatively neutral? 

Jose Torres 

I think they’re accommodative. If you look at bond spreads in the real economy and how risky borrowers can access capital and do all kinds of things. When you consider how strong real estate prices have been, how strong equity prices have been. Finally, “oh, we used to have rates like this back in the 70s.” The push and pull there, Steve, is the valuations, right? 

Back then, homes weren’t worth as much as they are now in proportionate to average incomes, right? That relationship is totally out of whack. We’ve learned effectively to live with the stock market valuations that in the past would get people scared. We’ve learned to live with them, and I think those are the crucial developments of today. 

Steve Sosnick 

Jose, I found this a very enlightening discussion. I certainly hope our listeners have. We’re going to wrap it up here. To everyone, thank you for listening. You’ve been listening to IBKR Podcasts. You can find all our recordings at ibkrpodcasts.com or certainly you can find the commentaries that Jose and I write along with several others from outside sources at ibkrcampus.com. Take care everybody.