Central Bank Week: A Busy Week for Central Banks

Podcast Intro:

From LPL Financial, welcome to Market Signals.

Lawrence Gillum:

Hello and welcome to another edition of LPL Market Signals. My name is Lawrence Gillum, fixed income strategist here on the LPL Research team, and I am joined with our Chief Market Strategist, Quincy Krosby. How are you today, Quincy?

Quincy Krosby:

I'm fine, thanks for inviting me to join you. I appreciate it.

Lawrence Gillum:

Oh, no problem at all. I couldn't think of a better person to discuss what's going on in the markets right now. We have a very busy week as it relates to central banks. 11 Central Banks meet this week starting today, in fact where we had our first surprise, we'll talk through that. But other central banks meeting this week, we have the Federal Reserve, of course, the Bank of England, the Bank of Japan, which may turn out to be an interesting meeting. So, we'll talk through all that. Certainly, want to talk about and get your perspective on equities. Equities have really moved lower since last week's higher than expected inflationary print. So certainly, want to get your perspective on markets and kind of what you're looking for and expect the rest of the year on markets.

And then finally, we'll talk about interest rates. You know, how much higher can rates go? We've seen a big move higher in treasury yields this year. So maybe we've seen the most of that move higher, but frankly, we'll get into how much higher we think interest rates can go from this point. But for sure, it's all about central banks this week. 11 banks meet this week an expected 500 basis points of rate hikes are priced into markets. It looks like it's going to be higher than that, given the surprise that we saw today with the first central bank meeting. The Swedish bank raised rates by a hundred basis points today instead of the expected 75 basis points. So right out the gate, we're already getting, you know, higher than market expectations in terms of interest rates. So busy week for central banks Quincy, kind of what are other not talking about the Fed just yet. We'll get into the Fed, you know, a lot more in just a second. But what are some of the other meetings that you're paying close attention to this week?

Quincy Krosby:

Well, I'm actually paying very close attention to Japan because the rates have been incredibly low. The dollar Japanese yen differential, just bizarre. And the question is, you know, are they going to intervene? That's the big question right now, is are we going to see an intervention from the Bank, bank of Japan? So, we'll see how it unfolds vis-a-vis their bank meeting, but also on the currency. It's important. We forget, Japan is the third largest economy, and also Japan is the largest foreign holder of U.S. Treasuries. Remember folks, they move back and forth with China who displaced them as the largest foreign holder of treasuries and also buyer of treasuries. But now Japan has got that first-place role again. So, it plays an important role even in our economy because, and I mentioned this, Lawrence, is whether or not the Japanese are going to pick up the pace of buying. We've talked about this before, because the more we have buyers come in, it helps bring down the treasury yields, doesn't it? It makes it more attractive. And we know that they have not been buying at the rate they've been. And a lot of it has to do with the currency differential. So, this is going to be an interesting day and or an interesting week because of Japan.

Lawrence Gillum:

No great points there, Quincy. And what's interesting too, with the Bank of Japan, they've been one of the outliers. They haven't been hiking rates like these other central banks have, but their inflationary print last night came in about 3%. So now there's more discussion or more chatter out there is that maybe the Bank of Japan has to be a bit more hawk than they've been in the past, which I never thought that that would be the case in my lifetime. So, we'll see if they actually do it. But you know, these inflationary pressures are global in nature as we know, and maybe they're leaking into the Bank of Japan's mindset as well. So, we'll have to see if they're able to actually raise interest rates like these other central banks. But I think your point about the FX transmission is an important one.

As we know, as the Fed raises rates here, that impacts currencies globally, and that impacts our trading partners and emerging market debt countries and their ability to service their outstanding debt payments. So, I mean, there's a lot going on, you know, these second and third order impacts of just interest rate hikes that are going to flow out into the real economy, especially as the pace of rate hikes continues to be higher than, frankly we've seen in quite some time. So, the other important bank, aside from the Fed, Bank of England, they're set to meet this week. The expectation is 50 basis points. Their economy's not doing great, though. So, I mean, I think the harder they push on interest rates, you know, we may see a slowdown in the Bank of England, or even in the eurozone, you know, more broadly. So, they're in a very difficult situation right now.

Quincy Krosby:

Exactly. They are, but then again, you also have a push on the fiscal side, which of course is the government side, right? Monetary side of central bank, fiscal side is the government side. And we may actually see the proposals coming out of the new government with Liz Truss, who is the new head of the government. She comes from the conservative party. She replaces Boris Johnson, but she has a number of initiatives that she wants to get through, which may you know, help the economy, but in addition, it could also help feed inflation. This is the difficulty that we have around the world. If you help on the fiscal side, the policy side, it may just then induce more inflation. But if you're a politician, you're not going to worry about that. You want to have a better approval rating when all is said and done.

Lawrence Gillum:

Yeah, no, that's, that's great points. I mean, one of the main responsibilities of a politician is to get reelected. And the easiest way to do that is to provide fiscal stimulus, which at this point in time, in these global economies, is only going to add to the inflationary pressures that we're seeing making central bank's job a lot more difficult. So, fantastic. Exactly. Fantastic point there.

Quincy Krosby:

Tug of war, tug of war.

Lawrence Gillum:

It is absolutely, it's a great analogy. So, turning our attention to the main central bank meeting this week, and that's the Federal Reserve. Market expectations are for 75-basis points on Wednesday, terminal fed funds around 4.5%. But, you know, what else are you looking for out of the meeting tomorrow, Quincy?

Quincy Krosby:

Well, above all else, I'm watching this statement but also the press conference. And the reason I'm doing that is that, you know, the market is, and I have to point out the initial knee-jerk reaction to the statement. And then as the press conference begins, comes from algorithms, and the algorithms pick up certain words. They pick up certain sentences, and they move accordingly, in a nanosecond, then, of course, that's followed by traders. But the point is that they're looking for anything that is either more hawkish than what he said in Jackson Hole, Wyoming. I don't know how you can be more hawkish, but if you are, it's going to pick it up, and I think it's going to push the dollar even higher. It will push rates higher and the equities go down. Conversely, the market also seems to, Lawrence, I don't know if you agree with me, but I've been following when the market shifts and starts gaining for example, just to give you an example, when he was up on Capitol Hill, I still call it the Humphrey Hawkins meetings, but they do an assessment of the economy.

But he made a comment and he said, he added this. He said, we are looking at economic data points. Remember he added that, and the market took that as, oh, so that does matter. So, raising rates, it does matter what happens to the economy. And suddenly we had the market climb higher. Now, again, I think it was the algorithms picked it up, but the market also picked that up. It shifted the mindset of how dangerous the Fed could be. Also, when he speaks at the press conference, I think the Fed knows this. They know exactly the words that he says and the reaction in the market. But if it has even a softish tilt to it, you could see the equity market rise, and you could see probably the yields pull back. And I think, you know, this is what the market is looking for.

Obviously, the, the reporters, Lawrence, are going to ask him those questions. At what point do you see the economy hurting where you, can't fix it. Where there's momentum on the downside. Someone's going to ask a question along those lines. And we want to see how he answers it. But, you know, I don't know. I do know he's mentioned Paul Volcker a number of times and I saw that the Wall Street Journal, you know, picked it up, his inner Volcker, which is very hawkish, needless to say. And then also, I do want to mention this, and then that's it. But they mentioned that the Fed now is focused on one of its mandates, and that is price stability. This is important because I think most folks don't realize our Fed is unique.

It has two mandates. One is to create an environment of sustainable economic growth, which is the labor mandate. And the other one is price stability. Other central banks, it is only about price stability. Now, here's the interesting point. Have they given up on the other mandate, the labor market? No, because one of the things he says over and over again is, you cannot have a healthy labor market ultimately, unless you have price stability. You cannot have a healthy economy unless you have price stability. And I think he may be forced to say that yet again, when folks say, well, you know, there are analysts who think you're going to push the unemployment rate above 5%, above 6%, if you keep going at this rate, he may have to repeat that line. Simply because the European Central Bank, Lawrence, if you remember, I think it was 2008 or 2009, as the world was realizing, sorry, realizing that portfolios were filled with subprime mortgages, you had Jean-Claude Trichet raised interest rates. Do you remember that?

Lawrence Gillum:

Yeah, for sure.

Quincy Krosby:

Remember that. And he was like, how could you do it? Well, because they have a mandate above 2% inflation, you raise rates, in fact, you don't have an option. It is built in. That's the way it is. When it moves that way, you don't discuss it. You just do it.

Lawrence Gillum:

Yeah, no, great points. And great, you know, points broadly. It's amazing to me though, how granular people try to kind of, you know, parse his words and comments and all this, and that reminds me of, you know, I'm going to age myself here, but reminds me of those days back with Greenspan, and they had the briefcase, and, you know, how thick is the briefcase and any indicator at all, but yeah. Markets, frankly, especially right now, are really living and breathing and dying by what the Fed is saying. And even isn't saying. So, there's going to be a lot of you know, focus on that. On tomorrow's meeting, what's also coming out tomorrow is four times a year they update their economic projections.

They're called SEPs or Summary of Economic Projections, where they forecast economic growth, inflation, the labor market. Now in June, you could make the argument that maybe things were, you know, painted a little bit too rosy a picture for kind of what they're expecting to do on the rate hike side. Yeah. And maybe it wasn't really filtering through on their expectations for labor market and growth and et cetera. So, we might see a revised Summary of Economic Projections making economic growth, a little lower, labor market unemployment rate a little bit higher and inflation may be a little bit more stickier. So, these are all things that could potentially move the market tomorrow.

Quincy Krosby:

Well, yeah, absolutely. But I do have to say, I don't know anyone who takes those reports those projections seriously, because even in the short term, they have to be revised. What about when they're looking out many years. I mean, it never holds up. I mean, you can't blame them because, you mentioned Alan Greensman said, he said, I can't even project what's going to happen over the next six months.

Lawrence Gillum:

Yeah. For sure. The other thing that I think maybe people take a little bit too seriously is the dot plots. Yeah. We're going to get a revised dot plot. And the dot plot is just the individual participants where they think the fed fund rate is going to be at the end of this year, next year, and then longer term. So, there is a, you know, looks like a Jackson Pollock painting with just little dots everywhere. But it is going to show presumably a higher median terminal rate relative to June. You know, markets expect a terminal rate in that four to four and a half percent range. So maybe we get something that could be a surprise there. But to your point, I think a lot of folks pay way too much attention to that as well. So that's something that markets will be watching for . <Affirmative> you know, with that release as well tomorrow,

Quincy Krosby:

Lawrence, do you remember, I think a couple of press conferences ago when they had this a while ago, he even, he even... the dot plots. You remember that? Do you remember Powell himself did?

Lawrence Gillum:

Yeah, I do. And I remember he's been saying this, you know, to take these dot plots with a grain of sand and, but folks don't, because it's being released by the Fed, and like we just talked about, they're going to parse everything and anything that comes out of the Fed for any sort of you know, maybe some secret message, we need our decoder rings on there to see what they're actually really meaning when they say this or what have you. Yeah. But yeah, unfortunately, markets do pay attention to that in the short term. So again, that's probably going to add to some volatility to the equity markets. Anything else on central bank week before we get into the equity markets?

Quincy Krosby:

Well, yeah, I do want to mention this, is that the market tends to do statistically extremely well right after the press conference. It is usually that day or that afternoon, the market, I want to say is it a hundred percent, but certainly at least 90% of the time it does extremely well. Maybe it's because Powell specifically, it's a softer tone when he's speaking and especially answering questions. And that market picks up rays of hope that maybe they'll be finished earlier than the market is projecting. So, the market tends to do well on press conference days.

Lawrence Gillum:

Yeah, good point. That hit rate is pretty high. And, you know, I think the Fed has a pretty, first of all, they have a pretty impossible task balancing their two mandates. But I think Jerome Powell does a pretty good job of communicating the Fed's intentions. And maybe, and to your point, maybe that does come off as maybe a bit more dovish than what the statements and the other releases may imply. But yeah, he does have a way of calming people's nerves after these releases and during these press conferences.

Quincy Krosby:

Lawrence, I have a question for you. What do you think? Yeah, no, what do you think, I mean, given that the Swedish Central Bank came in with 1%, yeah. We've had the Bank of Canada, not the last meeting, but the meeting before 1%, what do you think what the folks are saying that the Fed could actually do that? So, in other words, really front load get it done now while the labor market is still intact and come in with 1%. And here's the question for you. Given that Powell said, look, we're going to be data dependent that maybe the Fed feels that they did not have to telegraph to the market that they were shifting from 75 basis points, three quarters of percent to 1%, and then just does that, I'm just asking, what do you think?

Lawrence Gillum:

It's an interesting point. What's really interesting is that, you know, previously the Fed has kind of really followed the data and been data dependent. It seems like the Fed is really following kind of market expectation. So, I think if . <Affirmative> markets were saying that there was a greater than 50/50 probability of a hundred basis point rate hike, they would do it. But now markets are kind of back in this 75-basis point rate hike. So, I think that they're really paying attention to what market expectations are. So, it's certainly a possibility, especially after what we saw today out of Sweden. But . <Affirmative>, I still do lean towards 75 basis points. Yeah. As the rate hike. And remember, you know, what was it a couple meetings ago, not everyone agreed with the 75-basis point rate hike, right? . . <Affirmative> I think it was Loretta Mester from

Quincy Krosby:

Right. Yeah.

Lawrence Gillum:

I forget where, where she was from. But, you know, she dissented on this, given the fact that, you know, these rate hikes, they take a while to flow into the real economy, and maybe that, you know, being overly aggressive right now, sure, it might, you know, help anchor inflation expectations, but does that dig us into a deeper hole, a deeper recession down the line when these interest rates, eventually make their way through the economy. So, I do think it's on the table. I think it'll be discussed tomorrow, but I think we still lean towards 75 basis points.

Lawrence Gillum:

So, with that, let's turn our attention to equity markets. You know, it's been in a draw down here recently still above the June lows, but what are you looking at? What are you thinking about when you look at equities right now?

Quincy Krosby:

Well, you know, it was interesting is that the selloffs that we've had came just a tad above 3,900 on the S&P 500. Right? I mean, you have a really nasty selloff, and somehow it was just above 3,900. And of course, we broke it on Friday. You could argue that the market was paying attention to the rate treasury yields climbing higher, because we saw that on Friday, we saw the two year push higher didn't necessarily stick, but today it is, and we saw the 10-year push higher, but we also had the remarks from FedEx. Now granted there are many analysts who suggest, look, much of that had to do with specific FedEx issues, but they still are seen as a bellwether. And when you had a comment that it looked as if we were headed to a global downturn the selling picked up.

So, the question is, of course, do we break the lows that we had? And you know, it's very possible, especially if we see more revisions, negative revisions, early negative revisions, similarly, if we can have some positive comments and guidance before we really get into the earnings season, it would be helpful to anchor, I think, expectations on what companies are looking at. But I think it would not surprise anyone if the market, especially today, by the way, if he is a bit more negative, if he is seen as more hawkish, and then, you know, it's not enough to have him speak. So if he is a little bit softish what does the parade of Fed speakers then do when they start coming out with the same message? You know, how they try to switch it and say, oh, no, no, no, this is really what he meant, kind of, you know that could push the market lower. And again, we have to keep our eye on the yields. You talk about this, Lawrence, is the inverted yield curve getting steeper across the curve. I took a look at the three months and 10-year today. It's getting very flat, it's getting flatter. And folks, the three month to the 10-year, according to the San Francisco Fed is the one that has the edge on looking at impending or recessions correct.

Lawrence Gillum:

Yep, that is correct. And we're going to talk about just a second.

Quincy Krosby:

I'm sorry.

Lawrence Gillum:

No, no, no, no. It's a great point because yields and we try to glean these market signals from, you know, various markets. And right now, that inverted yield curve is telling us something that maybe we should be paying attention to with these rate hikes. So, and that certainly is going to impact equity. So, no we're going to talk about that, but that's a fantastic point, Quincy.

Quincy Krosby:

Well, thank you, Lawrence. I learned everything from you, of course. But people always ask what's so special about the three month? And the way that I explain it is, it's closer to the real economy. It's closer to what companies, how they see borrowing, how they see the environment, the economic environment, more so than say the you know, the two year to the 10-year. Similarly, you know, if you look at the two-year, that one is closer to Fed policy, right? Look at where that is today, the two-year, and then it filters down to the three-year the three-month rather. And that is one again, why did the San Francisco Fed close in on that and do the research on that? Because it's closer to the real economy. It's closer to how companies see the environment, how they view banks lending and ultimately default rates and so on. So, it's getting awfully close. Awfully close, this morning.

Lawrence Gillum:

Yep. For sure. And again, we'll touch upon that in just a second. One last question on the equities and your outlook for equities . <Affirmative> we're still a ways away from the unofficial kickoff to earnings season. I think that's still a couple weeks away. Correct me if I'm wrong there, but in the interim, it's going to be largely macro driven. And really markets are going to be focused on, you know, Fed and inflation and economic data, and maybe not have the same support from earnings if they are you know, a lot more positive than markets are expecting.

Quincy Krosby:

Well, we do have earnings. I mean, you know, I call it the official unofficial, starts with the banks, right? But we'll, hear from Costco, we're going to hear from a number of the housing builders reporting. So, we will get it, but we're also looking at revisions. And that's extremely important because you don't want to see a spate of negative revisions, because what companies will do, the way FedEx did is come out early and say, look, we're changing our view, but they also, if we have positive surprises, it would be very helpful. Before we get into the actual what is it, I think it's October 14, when we start that week, that starts the banks.

Lawrence Gillum:

Yep, yep. Yeah, the FedEx pre-announcement was a game changer for markets. And we certainly saw equities lower the next day. So, changing our attention to treasury yields. As you mentioned, Quincy, we have seen a big move higher in treasury yields. This is the 10-year treasury yield right now, we've seen about a 200-basis point, or a 2% increase in the . <Affirmative>, the treasury yield this year, about a hundred basis points or a 1% move higher in treasury yields last year. So, this 300 basis points move higher in treasury yield since we bought them back in August of 2020. It's the biggest move higher in yields since 1987. So, we have seen a significant move higher, and it's all because of these changing Fed rate hike expectations.

So yes, the higher the inflation data comes in, I guess the more frequently it surprises to the upside we continue to get higher yields in the treasury market. But to your point this inverted yield curve is something that we're paying a lot of attention to. This is the difference between two-year treasury yields and 10-year treasury yields, or three months treasury yields, and 10-year treasury yields. They are an important kind of market signal that we are paying attention to, listening to. And as the Fed continues to push rates higher, the front end of the yield curve continues to move higher at a faster pace than the intermediate or long end part of the treasury curve. So we are getting this inversion, and again, to your point, these inverted yield curves have pre-staged, you know, every recession over the past, I think it's 30 years or so, but yeah, certainly different tenors are more important than others. The three-month tenor as you pointed out, is the one that has the stronger academic backing from the San Francisco Fed, it's not inverted yet but it's getting pretty close.

That's something that maybe it's flashing a little warning signal that maybe the economy is about to enter into a recession. It's not our base case this year for a recession. We're about a coin flip that we'll see a recession sometime in 2023. But, you know, we are paying attention to these market signals. And right now, these treasury yields are kind of flashing yellow, if not red you know, currently. So, something that we are paying attention to. The other chart I wanted to show and certainly get your impressions on, this is the Fed's balance sheet, right? . <Affirmative> Quantitative tightening, this is going to be the wild card, I think, for markets over 2023. So, the Fed has a nearly $9 trillion balance sheet made up of treasury securities and mortgage-backed securities. It's about you know, 40% of GDP currently, they want to bring that back to 20% of GDP.

So, they want, you know, remove a sizable amount of treasury securities and mortgage securities off their balance sheet. So, this has only happened one other time, and it didn't really end well. So, this happened back in, in 2018, 2019, and they're only able to remove about $750 billion from their balance sheet. Now they want to take trillions off their balance sheet in a market, a treasury market, anyway, that's pretty illiquid currently. And there's a lot, you know, the economic data is weakening. And I mean, I think this is going to be a monumental challenge for the Fed to actually get their balance sheet down to you know, closer to 20% of GDP. But how do you see this playing out?

Quincy Krosby:

Well, you know, I go back to a comment when Janet Yellen was going to launch quantitative tightening, remember? And what did she say? She described it to the market as, don't worry about it. It'll be like, like paint drying, like watching paint dry. That's right. <Laugh>, like watching paint dry. And it wasn't like that. Yeah, I remember the repo market just, and you have to believe though, that the Fed is sensitive to that. They went through that, what was it, drying up of liquidity the overnight market. And they do work with banks, but as you've said so often, Lawrence, the liquidity in the treasury market is not what it was. And it's much more difficult. And it, I think by implication you meant it's not what it should be. Am am I right? You need more liquidity in that, especially during a period of quantitative tightening of draining the balance sheet.

Lawrence Gillum:

Yeah, for sure. And as the Fed steps away from some of these treasury markets, mortgage markets, you know, one of the responsibilities of the Fed is to make sure that these markets are fully functioning. And if the Fed as one of the largest buyers of treasury securities over the past few years, if they start to reduce their footprint, and we start to see the treasury market say malfunctioning a little bit then, and freezes up, like we saw right before the Covid shutdowns, I think that the Fed is going to be stuck in these markets for longer than they want to be. So, something again, to pay attention to. There was a research paper out of the Atlanta Fed recently talking about the impact of balance sheet reduction on financial conditions.

Again, it's not widely known. So, they have to do the research and they think that reducing their balance sheet by about $2.2 trillion over the next three years will add about 25 to 75 basis points of rate hikes in terms of tightening financial conditions. So, I mean, even with the Fed and there are other you know, economic folks over there, they don't really have a great understanding of how this is going to play out. So, it is something that we're going to watch and markets are going to be watching. I think it's going to be a big story for 2023. With that we'll kind of talk about the week ahead. It's not all about the central banks. Certainly, the central banks will be getting the most attention this week. There is also a lot of housing data that's coming out this week. And as we know the housing market is starting to show signs of slowing down a little bit. Anything else that you're paying attention to this week? Quincy?

Quincy Krosby:

No, I'm actually just watching really the rates, I think the rates are going to be guiding the equity market. And we'll see, you know, look, when all is said and done. We are still going to have an oversold market. We're going to have an overbought market. We're going to have to go through that process where buyers come in. But I'm paying very close attention to any guidance we have from the companies that are actually reporting this week. You know, they're on a different calendar. Not every company is on the quarterly calendar. So, I'm going to pay attention to that and just pay attention to yields. I think the story for the equity market is going to come out of the credit markets.

Lawrence Gillum:

So, as a fixed income person, we're not used to being the center of the universe. We like to stay in the background and eat lunch by ourselves. But right now, we are the center of the universe. And I think until the Fed starts to slow their rate increases and yields start to, you know, level out at certain levels, I think that's going to, until that happens, the equity markets are still going to you know, experience a lot of volatility as well. So, with that, we will wrap it up. Quincy, thank you so much for joining today. Fantastic insights. As always, Neal, our fantastic producer, best in the world as far as I'm concerned. Thanks Neal, for, for putting us together and making it ready for public consumption. And then of course, thanks for listening. To all the listeners out there, we will be back next week, same time, same place. Until then, hope everyone has a great week. Take care everyone.

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