Patient and resolute
July FOMC highlights
The Federal Open Market Committee (FOMC) unanimously voted to raise interest rates 25bps. The new target range is 5.25%-5.50%—the highest level in more than 22 years—yet we may not have reached the peak. Interest on reserve balances and the overnight reverse repo rate were also increased by equivalent amounts to 5.4% and 5.3%, respectively.
The result of the meeting was largely anticipated, but the market was also hoping for some guidance on the potential for future hikes and what the cadence might be. Instead, we got a Fed that wants to exit the forward guidance market, with Chair Powell explicitly stating that the Fed is not ready to provide forward guidance on upcoming meetings. Powell’s and the Fed’s preference is to look at the “totality of the incoming data” and make meeting-to-meeting decisions. He then chose to highlight that we have two Consumer Price Index (CPI) prints, two labor market prints, and an Employment Cost Index (ECI) print all before the September meeting. Ultimately, every meeting is live, and while the last CPI data looked promising, suggesting lower inflation, it was only one data point. The Fed is prepared to be “patient and resolute.” As Powell stated, it is possible the Fed raises rates in September but also possible it doesn’t.
The market is currently pricing in about a 21% probability of a September hike and a 40% probability of a November hike, with a peak rate of 5.38%. The Fed’s press conference and statement did little to sway the market in either direction and expectations for Fed hikes remained relatively unchanged. Ultimately, this is probably right where the Fed wants to be and leaves the door open to both hiking or pausing at either of the next two meetings.
The Fed made no adjustment to its balance sheet reduction, which continues to run in the background at a targeted pace of USD 95 billion a month (USD 60 billion in Treasuries and USD 35 billion in mortgages). While the purpose of QT, or a shrinking balance sheet, is to remove excess liquidity, there potentially could be a time when liquidity gets too tight and directly impacts short-term rates. Some feared that while QT was running in the background, a sharp rise in the Treasury General Account (TGA) following the debt ceiling resolution could hasten the drain on market liquidity and lead to a scarcity of reserves.
Since the beginning of June, the Treasury has increased its TGA over USD 500 billion. The TGA is a liability on the Fed balance sheet; as it increases, another liability needs to decline to maintain the size of the balance sheet. The offsetting decline could come from either reserves or the Fed reverse repo program (RRP). Until now, the RRP has acted as an outlet for these Fed balance sheet adjustments and has helped to absorb higher TGA balances driven by increased Treasury bill issuance following the debt limit resolution and a shrinking balance sheet from QT. With RRP daily usage over USD 1.7 trillion, its capacity to absorb a further build in the TGA, as well as a continuation of the QT program, remains high.
Implications for investors
The pass through of monetary policy is fast in money market funds due to their short duration and yields on Global Liquidity’s suite of USD money market strategies have adjusted quickly through this cycle. Global Liquidity’s money market funds remain conservatively positioned with historically high levels of liquidity and will continue to benefit from high absolute yield levels.