October 19, 2023
Takeaways from Powell’s anticipated address to the Economics Club of NY seem a bit more dovish than the consensus message from other Fed officials over the past two weeks. Powell referred to ‘significant’ tightening in financial conditions and called out ‘highly elevated’ geopolitical tensions as a risk to global economic activity. He said the central bank will ‘proceed carefully,’ which suggests no rate hike at the November meeting. As expected, there’s no explicit declaration that the Fed is finished hiking. An eventual end of the hiking cycle shouldn’t be conflated with the end of the tightening cycle. Yesterday, Fed Governor Waller said the balance sheet can shrink by an additional $2-2.5T as QT operations persist for a ‘long time.’
Yesterday’s Beige Book (qualitative economic conditions from all 12 Fed districts) described an economy that’s slowing at the margin. The renewed backup in bond yields is getting outsized attention as reports suggest the White House will ask Congress for $100B in additional spending for Israel, Ukraine and border security.
The resumed backup in bond yields is the biggest near-term threat for equity markets. Three weeks ago, we flagged the disconnect between current yields and their fundamental drivers, suggesting unfavorable supply/demand dynamics and concerns over large, growing US fiscal deficits were largely responsible for the backup. The Fed’s ongoing QT operation and increased Treasury issuance are the two largest contributors to the unfavorable supply/demand backdrop, while ‘bond vigilantes’ return to address uncontrolled fiscal spending in Washington. The term ‘bond vigilante’ was first used back in 1983 but is more often associated with the ’93-’94 period of increased fiscal spending and rising US deficits. The term refers to the absence of political will to address record high deficits and public debt. In the ’93-’94 period, ‘bond vigilantes’ took 10-year yields from 5.2% to 8% before the electorate found the will to change the makeup of Congress. Ensuing efforts to reduce fiscal deficits took 10-year yields back to 4%.
Markets are leading indicators and ongoing weakness in the Russell 2000 (RTY) is an early warning of slowing economic activity ahead. Other cyclical proxies like the EuroStoxx 50 and Copper/Gold ratio issue a similar warning, while the 2/10 yield curve inversion moves closer to its predictive window. The 2/10 curve has been inverted for 16 months and has