Task force hawkish

Hello, and welcome to Global Research Unlocked, the interest rate in FX series. This podcast is based on our weekly client conference call where our strategists, along with guests from other parts of Bank of America Global Research, discuss the most topical and pressing questions faced by our market. I'm Mark Cabana, co-head of U.S. rate strategy at B of A Securities.

Good evening, everyone. Thank you for joining us on today's call, obviously a momentous FOMC meeting. I like to remind folks that we don't have a ton of Fed chair transitions.

We've had only, this is the fourth one in nearly 40 years, so much more rare than a World Cup final. And certainly things changed a lot today. So let's start with the statement, Stephen, sorry, let me start maybe by just introducing the folks on this call.

I'm Aditya Bhave, I lead the U.S. economics team, and I have the pleasure of being joined by my colleague, Stephen, who will speak in a second. He is our senior U.S. economist, and also Mark Cabana, our co-head of global rate strategy, and Alex Cohen, our senior G10FX strategist. So with those introductions done, Stephen, what did you see in the statement?

What do you think was interesting? Thanks, Aditya, and thanks, everyone, for joining. Obviously an interesting meeting, a very interesting statement.

I guess what really struck us at first was just the length of the statement. So we saw 130 word count. That was down from an average of about 250 words to start the year.

It really looks like a length of a statement that we saw prior to the GFC. I mean, looking back at these things, in August of 2008, you had 180. It very much looks like, say, a Greenspan-era statement.

Before we saw this, that really adopted much more forward guidance, more communication, obviously, before the balance sheet was used as a tool as well. So you saw big changes in that regard. I think another thing that stood out is they didn't list the people who voted for the action.

Obviously they did start with the fact that the committee approved the following statement for release by a 12-0 vote. So unanimous decision. But previously in all these statements, really even going back prior to the GFC with Bernanke, they would list out who voted for each action.

So we'll be curious to see. We didn't get dissents this time, but will that mean that dissents don't have to be named? Will they just come out kind of after the fact?

Of course, we should still hear from the dissenters eventually, but it's a different kind of dynamic there. Lastly, I'll just say this because it was obviously brief, so there's not too much to talk about. But what I'll say that I guess stood out the most was maybe the last paragraph.

Inflation remains elevated relative to the committee's 2% goal, in part stress on that reflecting supply shocks that have driven price increases in certain sectors, including energy. And finally, closing with the committee will deliver price stability. So no real mention of the labor market here, no real mention of the maximum employment mandate, only attributing some of the increased inflation to supply shocks.

So obviously in line with, I think, what we saw in kind of the other communication. So I'll maybe stop there and just allow Aditya to kind of talk about the rest of what we heard, what we learned from today's meeting. Thanks, Steven.

So the SEP was unambiguously hawkish in my view. The first thing I'd note is that Walsh, consistent with our expectations, did not submit a forecast. I think this makes sense.

It's a way of, you know, him undermining the SEP because he doesn't like forward guidance without essentially antagonizing the rest of the committee by getting rid of it. So what did we see in the SEP? Starting with the dots, we saw nine of the 18 other FOMC participants projecting rate hikes this year, three of them for 25 bps, five of them for 50, and one for 75.

So essentially half the committee thinks we're going to hike and the other half thinks we're going to be on hold and then barring one person who thinks we are going to cut rates. So a huge move in the dot plot. And I would also note that the dot plot shows eight folks who have policy rates higher next year than this year.

And despite that policy stance, the median inflation rate for 2027, not 2026, but 2027, is still 2.5% on the core PCE. So you put that together and you have a committee that, from my perspective, is really concerned about inflation persistence a lot more than it was earlier, because one could still potentially make an argument. I wouldn't find it super convincing, but one could make an argument that a lot of the inflation that we're seeing right now will wash out of the year-over-year rate by the end of next year.

So if they wanted to be dovish, they could have gone down that route. They decided that even though they were now projecting much more restrictive policy or somewhat more restrictive policy than they earlier were projecting, they still think inflation is going to be higher. So we thought that was quite meaningful.

The other forecast changes in the SEP, I thought, were relatively minor. We don't really need to go into them unless there are questions. Let's talk about the press conference instead.

So the first thing Walsh did, I think, was he emphasized, obviously, the Fed's commitment to price stability, and this was a theme throughout his press conference. And on net, I think the press conference was hawkish, but the other thing he talked about a lot was his task forces. So he said that the Fed is going to establish, or he has established, five task forces to review Fed communications, the balance sheet, the quality of the data that the Fed uses, the public data, productivity, and the Fed's inflation frameworks.

And he said that the task forces will wrap up their work by the end of the year, and then they'll present their recommendations to the FOMC, and the FOMC will decide what changes it wants to make. On the one hand, he said he doesn't want to prejudge the task force's findings, but on the other hand, he heavily hinted, in my view, that the end result on communications would be substantial changes to the full suite of communications. And on data quality and inflation, he repeatedly said that the Fed should focus on real-time data rather than backward-looking data.

I think if you're looking for a few dovish nuggets in his press conference, there were a few, and this, I think, was one of them, because one of the better-known real-time inflation indicators, or maybe the best-known one, is trueflation, and that has been running way below PCE inflation, probably below CPI inflation as well. So, you know, that was one place where Warsh sounded a little bit dovish. More broadly, though, he evaded most questions on the economic outlook.

He kind of said, he essentially suggested that any answer on economics would be forward guidance. I find this a strange way of communicating, but that's his view. So it sounds like we're not going to get much from Warsh on the economic outlook, maybe never, right, because he believes that this is forward guidance.

What he did say was he was asked whether policy is restrictive, and he said it looks like it's restrictive vis-a-vis the housing sector. It really doesn't look like it's restrictive vis-a-vis other sectors in the economy, including financial services, sorry, the financial markets, and I think that's a perfectly reasonable way of seeing things. So on net, it sounds like he doesn't think policy is very restrictive.

On inflation, again, he repeatedly said we have to deliver price stability, we will deliver price stability, and he said we've got some work to do on that front. So that was, I would say, hawkish as well. On the labor market, he said it looks stable.

Some folks thought it was accelerating, but he also said that we don't want to stand in the way of productivity-driven acceleration in the economy, which you could view as a little bit dovish. In other words, he might want to see the labor market tighten a little bit more in order to be fully on board with rate hikes. But if I were to distill his message, I would say, one, he's very evasive on economics.

He really doesn't want to talk economics. Two, he's kind of waiting to make big changes. He's kind of waiting to see the task force results to make big changes, but he really sounds like he's going to be nudging the task forces in the direction that he wants them to go.

And three, he probably was hawkish on net. I think he was more hawkish than he was, for example, in his testimony, right? He leaned more into the dovish arguments in his congressional testimony.

So what does this do for our forecast? We don't have the Fed doing anything for the next year. I think the implication here is obvious.

The risks are that the Fed is going to be more hawkish and the risk of a rate hike, in our view, has increased meaningfully after today's Fed meeting. So with that said, let me hand over to Mark to talk about the market response. Mark?

Task force hawkish. This, to me, was so much more hawkish than we could have expected, and we thought it was going to be hawkish. Here's what really stood out to me.

Dot plot, nine people wanted to hike. Nine. Half of the committee wanted to hike, or at some point this year.

That, to me, sounds like the hike is now more of a matter of when, not if. Second, the revisions to core PCE were quite astounding. So N26, core PCE at 3.3%, I mean, you're missing by a lot at the end of the year.

And at the end of next year, 2.5% on core PCE. You're not even rounding down to target at the end of next year. Finally, that press conference.

So what I heard was Warsh clearly reiterating his commitment to getting inflation back down to 2.0%, not 2.9, after missing the target for five years. And to reiterate Aditya's point, this really resonated with me and my team. Warsh acknowledged that monetary policy is not restrictive anywhere but the housing market.

That's not uneven. That's one segment of the economy, an important one, but one segment of the economy, while it's not restrictive anywhere else. Wow.

So what do you do with that? You pay the front end. What was most striking to me, and this is something that I think the market and myself are going to have to get adjusted to, but the lack of forward guidance from Warsh means that he's not going to tell you that you're wrong.

And when you ask yourself, well, if monetary policy is really not restrictive anywhere else but the housing market, and if we kind of agree that the setting of monetary policy is wrong, then you can really push this thing. And where can monetary policy go? Well, if you use Standard-Taylor, at the end of this year, using the Fed's own SEP projections, Standard-Taylor would tell you that the funds rate should be 5%. 5%.

So you're wrong by hundreds of basis points. And if the market's going to push this thing, and if the Fed comes around to the view that monetary policy really isn't that restrictive, then watch out, because you can really push this Fed, and he's not going to tell you that you're wrong. And I do think that there is some runway on this.

By the way, retail sales was also really strong this morning, and kudos to a DTN team and our Bank of America Institute team for having the credit and debit card data to see that in advance. They had a great call on this. But the consumer is not slowing down.

If anything, they are speeding up. The fact that oil prices have come down should be a net stimulus to the consumer that is already charging ahead, and that's going to make it look even less likely that monetary policy is restrictive. We're not even pricing in 50 basis points when Taylor tells you that 5% is the value that you need with that set of median economic projections.

On the balance sheet, very small changes outside of the task force, and we expected that Warsh's first move would be to form a, we were describing it as a working group on balance sheet and other items, task force I guess is the name we're going to use, but a couple of things that stood out on the balance sheet, and the bottom line is that there's no problem for asset swap spreads here in the near term. No problem. Be long spreads, keep riding the carry and roll, you're going to be fine.

They're not going to get in the way, at least no time soon. All right, so a few things that stood out. First, the June FOMC statement did include a new line that said, quote, the committee reaffirmed its policy of maintaining ample reserves in the banking system.

I mean, I heard the word ample more times this afternoon than I have heard almost in like years under Powell. So we were worried or we were questioning, will Warsh be team ample or team scarce? We know unambiguously now he is team ample.

Second, in the implementation note, there was a couple of new words that were added on an RMP related line, and those words were, when appropriate, those were the two words that were added, but then it says, increase the system open market account holdings of securities through purchases of treasury bills. So when appropriate. So I think what they did with that is to say that RMPs are not on a preset course, and the Fed could do zero for RMPs for a period of time.

For what it's worth, this was already our understanding, so really no surprise there. And then finally, on the task force, Warsh did say that the task force would focus on size and composition. Again, no surprise there.

We think on size, there's actually very little that the Fed can do that will have really moved the needle type of impact, but they will likely and primarily focus on bank liquidity rule changes that are designed to reduce bank demand for reserves. Those are coming, I still think, now that Warsh got through the June FOMC, I think we'll probably get something in the next month. I've been telling people I've kind of soft circled July 4th, give or take two weeks for when we get some detail on the bank liquidity rule changes.

So I think they're coming, and I do think that that is going to be where he wants to go. And then on composition, to us it's pretty obvious what composition changes they're going to do. They're going to allow mortgages to continue to roll off and reinvest them by buying bills.

They're going to target a treasury only portfolio over time, but not sell mortgages to get there. And they will shorten the current weighted average maturity of the treasuries that they hold, which is just a hair under nine years now, and they're going to probably target a weighted average maturity of around three years. And in order to speed up that process, to shorten the weighted average maturity of their treasury holdings, they will likely adjust their reinvestment policy so that instead of rolling over into longer dated tenors, as they currently do, they will roll over only into two or three year treasury coupons.

That's going to speed up the weighted average maturity reduction in the Fed's portfolio. But again, we kind of expected that, it doesn't really have a market implication, especially if treasury does not offset the Fed's adjustment, which will mechanically shorten the U.S. Treasury's weighted average maturity.

If Besson doesn't offset it, then it has no market impact for investors. So to summarize, very hawkish, stay paid the front end, stay in flatteners, stay both nominal and breakeven. Let's pass it over to Alex to discuss FX.

Yeah, thanks, Mark. I mean, try not to sound like a broken record here, but basically cosine everything you just said on the market, unambiguously dollar positive event here. It was quite a surprise, I think, to even the most hawkish leaning views out there on what could be delivered.

So what do we see? We saw the dollar up about a percent against the euro, other currencies as well, but just notably against the euro since the statement release. We're now net stronger in the dollar since we saw the dollar sell off sharply on Thursday's announcement of a Iran agreement or MOU or whatever we think that is now.

So we've kind of wiped out that price action. Again, also kind of notable here, less of a move. It was about a four tenths of a percent move.

So a bit more modest there, but obviously there's a lot else going on there. You know, the pair hit fresh new highs for the cycle for the last few years. And of course, we're kind of creeping back into what could be the intervention zone there.

So another thing to keep an eye on. But yeah, just a hawkish surprise to the FX market. You know, I think we all expected the statement in SEP to just present itself as hawkish, but certainly no one thought the number of dots coming in was going to be this many calling for a hike.

You know, I think as far as Warsh goes, just to my ears, you know, I just expected him to at least mix in a few more dovish arguments in plainer English than he did and just take him at face value. I mean, just what struck me is he just he kept reaffirming this desire to get inflation back. He even referenced the fact that it's been above target for five years.

I mean, it seems pretty clear over and over again throughout the presser. So I think the dollar kind of clung to that. You know, on the back of these big moves, you know, we'll probably get some consolidation just given how big of a move it was.

But ultimately, you know, we are and have been recommending playing dollar from the long side, and we will continue to, you know, see that as certainly our near-term outlook. A lot of this view is really on data outperformance and, you know, the last several labor prints. I didn't think it was predicated on the Fed turning potentially this hawkish this fast.

But also sort of the flip side is that, you know, a lot of other central banks and a lot of other currencies, we thought their central banks were either, you know, unlikely to deliver or unlikely to deliver for a durable amount of time the hikes that were priced into their curves following the start of the war. So we've started to see those kind of pare back a bit. And now that's contrasting with the Fed that's, you know, certainly expected to pivot a lot more in a hawkish direction here.

So a nice recipe for dollar bulls. So I will stop there and pass it back to you guys. Thank you, Alex.

Thanks, Mark. That concludes our prepared remarks. Operator, if we could open it up for Q&A, please.

Thank you. And we will go to our first question. Yeah.

Thanks for giving us this opportunity. Matthias Joers from Zolitic Invest. Short question.

As he's obviously not guiding us any longer on the economy and his outlook in general, what does it mean for the move index from your perspective? Thanks. Yeah.

Higher. I think vol everywhere should be a bit higher simply because the Fed decision-making process will be a bit more volatile. And you would think that asset markets should also reflect some of that volatility.

Thanks. Not really seeing it, but I still sense that the market may not fully believe that we can live in a world without forward guidance. But that seems to be the world that Warsh wants to live in.

Thank you. We'll go ahead and go to our next question. One quick question.

So, Mark, why do you think the overall long-term asset swap curve? Okay. I'm sorry.

You sounded very faint. I think it was a question for me about the asset swap spread curve. Yes.

Correct. Okay. So, my comments on asset swaps were really rooted in a lot of questions that we have been getting from people who trade asset swap spreads.

And their questions have been really, to my ears, wondering, will the Fed do anything on the balance sheet that creates a lot of money market or funding market volatility that could potentially disrupt any long asset swap spread view? And I'm really thinking about spreads at the front end of the curve, really in the two- to three-year sector, where, according to client feedback, positioning is very heavy in the long side. And my comments were rooted in those questions.

So, did we learn anything today that would tell us that Warsh is going to change anything with the balance sheet that will create funding volatility? And my resounding take is we learned that he's not going to rock this boat, certainly not right now. And the fact that there was a line in the statement that reflected a commitment to ample reserves, and Warsh did mention on several occasions in the press conference that ample commitment means that he is not going to, in one of his first acts, do anything that is rash or really aggressive on the balance sheet.

He's going to stay committed to ample for now, and then we'll see where the task force comes out in the future. And if they stay committed to ample for now, that means that the Fed will continue to anchor money market rates in the Fed's target range. It means that the Logan ideal of essentially SOFR equal to IOR, which is how I interpret Logan's discussion around the Friedman rule, will continue to apply for the foreseeable future.

So, if that's right, if the Fed is committed to ample, and it essentially means SOFR equals IOR, then you're not going to see the funding ball, and that should be supportive for being long asset swap spreads, especially at the front end of the curve, again, in an environment of yield-seeking and carry-seeking type behavior. I think as everybody who is familiar with asset swap spreads know, at least in the dollar space, it's one of the best sharp ratio trades you can do because it carries and rolls so well, and there's such limited volatility that goes along with it. Thank you.

Great. Thank you to everyone for joining us today. Interesting times.

There's certainly going to be a lot more to talk about in coming weeks, so if you have any follow-ups, if you want to dig deeper into any of the issues we talked about today, please feel free to reach out to us. You can email us. You can ping us on Bloomberg.

We're always happy to keep the dialogue going. But if not, hope you enjoy the rest of your summer and enjoy the World Cup. Bye, everyone.

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