Interview with Robert Kaplan: What Fed Chair Powell Presser Signals

What's Driving the Bond Market Selloff and Why It May Continue

·    Today immediately after Federal Reserve Chair Jay Powell wrapped up his post-FOMC meeting press conference I spoke with the former president of the Federal Reserve Bank of Dallas and former Goldman Sachs vice-chairman, Rob Kaplan. He says while the bar is higher now for the Fed to hike rates again, the option is still on the table. As for the bond market selloff, it may not be over yet. See his analysis of the interaction of debt, deficits and bonds with the Fed’s policy options below.

The interview has been lightly edited to smooth the bridge from the spoken to the written word.
 
Q.  So Rob, the Fed kept its key rate unchanged as expected. What is Jay Powell's message?

A. That the Fed is not moving right now but that they leave the option to move in the future. And they're going to take it meeting to meeting, and he's not going to pretend that he can prognosticate the future, and he wants to prepare people that they're going to leave their options open even though they're not moving today.

 Q. How much would you say Jay Powell himself sounds inclined to hike the key rate again after the first of the year and not turn the current pause into the END of rate hikes?

A.  If I were at the Fed I'd be very cognizant that we've moved a long way very fast, that we may be either at the end, or at a point where we have very few moves left and when we look back a few years from now it'll be these last moves that will be most heavily scrutinized, or that I might regret. What I'd be looking ahead to is how long are we going to keep rates at this current level so I think the bar is higher for moving rates again.   That doesn't mean it won't happen but the bar is higher.
      I think there’s a lot of the debate around the FOMC table and in his mind and in in the minds of people around the table and the question is going to be what criteria am I looking for to be able to start cutting rates sometime later next year.

Q. Powell did seem very ambivalent. He left the door wide open to another rate hike in the context of trying to figure out if the Fed will have to move to  hike a again.  And on the other hand saying the Fed is certainly not trying to figure out if they have to CUT rates again as  he seems to think that still a long ways off.

A. I would liken this to Powell being very aware that the Fed’s forecasts have a bad habit of being wrong, and so I think you as Fed Chair want to be very deliberate in what you might do next and that would be dominating his thinking. I think if if they could achieve their objective without making another move it would be preferable (to him (and the FOMC) because he's aware of the jarring impact of what they've done already on certain sectors of the economy.

Q.  Do you think he’s afraid to come off sounding more dovish? To acknowledge more directly that the Fed could be at the point where it doesn’t need to do more rate hikes because it will give the bond market the sense that they are are getting ready to open the door in the other direction (to rate cuts) and that cause bonds to rally and provide more stimulus to the economy?  

A.  I think it would be easy to get good news (and communicate that to markets). It's harder to communicate more cautionary news. I think in light of that it's wiser to for him to be more hawkish than dovish right now in order to leave your options open.  Because what you don't want to do is to sound dovish today and then have to act in a hawkish matter later and it make it look like you've reversed yourself.

Q.  So what about the bond market rally? How much have financial conditions eased? How much difference does it make it make to the Fed’s outlook? Powell seemed to downplay that side of it.  

A.  We have had a very substantial backing up in the five- year, the 10-year and the 30-year bond yields since the spring and the net of that is a tightening in financial conditions. They noted it in the policy statement where they changed from only noting  tighter credit conditions to looking at tighter financial AND credit conditions.  So they're obviously aware of it.
    Here's the issue in the background for the bond market which he doesn't talk about, but I'd be very aware of: the backing up in the in the 10 year (bond yield) is linked to one of the big reasons why the economy's been so resilient.
      We just finished the 2023 fiscal year, ended September 30^th, where we ran a historically high deficit as a percentage of GDP approaching $2 trillion.  That is a deficit you'd normally associate with either a crisis or recession, and we had neither. In fact we had more benign conditions and we ran a historically high deficit and now we have debt to GDP over 100%. And we have a very substantial forward supply of treasury offerings this year and next year
      The bond market is backing up because the Fed is not buying these bonds any more. The banks are not buying these bonds to a great extent anymore. So there's some concern in the bond market that they need greater compensation in order to buy the five-year, the 10-year and the 30- year.
      Government spending is not only making the economy more resilient, the consumer more resilient, and the job market more resilient. It's increasing the deficit, it's increasing debt to GDP, it's increasing the forward supply of treasuries and what the treasury market is thinking about is you know we need higher compensation.  It’s also looking over the horizon to a day where the Fed funds rate in a couple of years is down to say 3 1/2 percent you know a real fed funds rate of 1/2 to 3/4 plus an inflation rate of 2 1/2 to 3% and then add 150 basis points per term premium and it explains why the market is backed up this much.
      The reason I stress this is that is  added to the tightening, added to what  the Fed has already done (with rate hikes and quantitative tightening), and it’s coming with this recent further tightening in financial conditions.  And so  I'm not sure this bond run up is over.
      Why might it not be?  You know the interest expense in 2023 is $620 billion. And remember the everybody in a lot of sectors termed out as a result of low rates.  Mortgage owners, homeowners termed out heavily, maybe not completely but heavily. Big businesses termed out their debt.  The one sector that did not term out is small businesses. They didn't term out because they don't have that option.  They were relying on bank financing.  The government did not term out and so the average duration on the treasury market is now about 3 1/2 years.
      So you can see time is not our friend.  We are now going to have approximately  a third of the debt reprice every year to higher rates.  We're going to approach $750 billion next year and then on our way to a trillion dollars in interest expense a couple of years from now.  The bond market is watching all this and saying we've got a big forward supply of treasuries, and interest on them that is increasing. We're gonna have to borrow even more to pay that interest. 
      This is a dynamic that's going on away from the Fed but the Fed’s got to be very aware of it and and it needs to be watching it very very carefully.

Q. How do these dynamics affect what steps the Fed can or should take now?

A.  As for the Fed’s  job now they're dealing with the impact of all the fiscal spending linked to the debt and deficits that are driving the bond market now: the inflation reduction act, the infrastructure act, the unspent ARPA money.  With all of this in play it's not surprising that the consumer and the job market have been so much more resilient than people might have expected even with all of these rate increases the Fed has done  It’s because we had and still have fiscal accommodation in a significant size. The only issue around this is that very few people in the government seem to be willing to acknowledge that,  but I think in the private sector and in the markets they're very, very cognizant of it.

Q,    Where does the situation in the bond market  leave the Fed in terms of its policy path over the end of 2023 and going in to 2024?

 A. I think in our lifetimes we're accustomed to thinking the long end (of the Treasury bond market) is a little more influenced by the Fed and and I think today there's a different dynamic. Debt and deficits have gotten to a level that I think they're (starting to drive) the process of setting the right rate for the 10 year bond yield. It's not unrelated to the Fed but I would argue it's a little less related to the Fed than it's been in decades. Now the level of bond yields has more to do with the deficit process and the supply demand of bond buyers and the fact that the Fed is running off its balance sheet so they're not an incremental buyer the way they were. 
     So the impact on the front end of all this fiscal spending is it means the Feds got to be prepared to act again although they hope they won't have to and they also have to be prepared to keep rates at this level for longer.  I would think you're going to see  the futures markets, if the first rate cut maybe six months ago was priced in the spring, and then you notice it moved to June, I think you're going to see it now move out to maybe closer to September before the Fed can cut rates. T he resiliency of the economy, where a big reason for it is the fiscal spending --  it will  it means for the Fed higher for longer if the if the back end of the curve continues to move back up. I'm sure there'll be a point at which the Fed is going to have to have a conversation down the road about how much longer to continue the runoff of its balance sheet.

Q. What is your sense of the debate within the Fed now. Do you see potential dissents? We certainly have a contingent that looks more ready to pause, not inclined to raise rates more versus another contingent that wants to make sure the Fed has done enough and is more ready to hike again.

A.  I think everyone around that table is trying to make the right decisions. I think they're dealing with a dynamic that is a little broader than data dependence. I think you're dealing with (the ongoing impact of) the stimulus-oriented Inflation Reduction Act, the infrastructure act, the unspent ARPA money. I think that adds an X-Factor that complicates the analysis.
I think every person around that table has a different background, either PhD economists, not so many business folks, and I think it seems like it's unusually challenging to analyze the economy right now and predict it and and say with clarity what should be done next. That shouldn't be surprising because I don't remember a hiking cycle like this in the past where you had an offset (to hikes) to some extent from fiscal policy and that cross dynamic. I'd be I'd be finding it challenging to analyze that too but to me it means that a a downturn is less likely than it would have been. It means the Fed may have to do more than it would have although I hope not and it mean rates are likely to stay higher for longer into next year than they would have if this fiscal stimulus and deficit spending weren't going on the way they are .

Q. One last, quick question. As for the Fed’s next move, are you ready to bet that if there is one more rate hike it will come at the first FOMC meeting next year?

A.  I don’t make bets now. If you had asked me this when I was at the Dallas Fed I would have said, I don't have an answer for you and I don't need to have an answer.  My job is to manage the risk, it's not to be a prognosticator. I think I need to be prepared and we need to leave that option open and so that that would be my answer.  

Rob, thanks for taking the time to join me today and for this great conversation.

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