The Fed exit begins

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PRIYA MISRA: Hello, and welcome to Viewpoint, at TD Securities podcast. Today we're discussing the Fed exit, which is ultimately a function of the outlook for the economy and the Fed reaction function. The economy and markets have been operating under significant monetary accommodation since COVID. So the timing, face, and nature of the Fed exit from this accommodation can have pretty big implications for the economy and different asset classes. My name is Priya Misra, and I run global rate strategy at TD Securities. I'm joined here with Jim O'Sullivan, who is the Chief US macro strategist at TD. This conversation is timely, as we recently heard from Fed Chair Powell at the annual economic symposium in Jackson Hole. It's also critical as we head to the end of the year, where in our view, the Fed is likely to announce the first step in reducing its support by tapering its QE program. Note, that since QE began in March 2020, the Fed has bought $2.8 trillion in treasuries and over $1 trillion in mortgages. Markets are a little bit on edge, and the nervousness has been building as Delta cases have been rising, global growth seems to be slowing a little bit, and the Fed is inching towards ending its asset purchases. Ultimately, different markets have to factor in whether the nature of the Fed exit is appropriately calibrated to the evolving economic outlook. So let's get to it, and I'll start with Jim with what we heard from Chair Powell at Jackson Hole. Jim, any surprises in the speech? And what is your forecast for the Fed exit?

JIM O'SULLIVAN: Thanks, Priya, and hello, everybody. Well, on Jackson Hole, no major fireworks, no. I think some people were looking for a big announcement, or at least a major market-moving shift in tone, but the speech was quite similar in message and tone to what came out of the last F1C meeting a month ago. In short, I mean, the Fed is clearly getting ready to start winding down its Quantitative Easing, QE, program by tapering the amount of bonds it buys each month, but they're not in a rush. And the chairman once again signaled that it would probably happen this year, the same this year wording as it was in the minutes from the last meeting a couple of weeks ago. And that suggests to us an announcement from the Fed at either the November or December F1C meeting, but not as soon as the next meeting in a few weeks' time in September. The two other key takeaways, both of which made for a relatively dovish tone, at first he made clear once again that the criteria for raising the funds rate, liftoff as they're calling it, are very different from the criteria for winding down QE. Tapering just requires what they're calling substantial progress, substantial further progress toward their goals of maximum employment and 2% inflation, while rate hikes will require full mission accomplished in terms of those goals, and even some overshoot on the inflation side. Second, he pushed back pretty strongly against the view that the recent pickup in inflation is more than a temporary development due to post-COVID reopening, adding that with the labor market still far from recovered, a policy-based-- a policy change based on an only temporary increase in inflation would be a big mistake. All in all, again, a fairly dovish tone. We're inclined to agree with his points. And while we expect tapering to be announced this year, probably in December, possibly November, and we expect the tapering process to be finished by late next year by around October of 2022, we don't expect the first rate hike from the Fed until the end of 2023.

PRIYA MISRA: Thank you, Jim. From a market standpoint, interest rates did fall after the Jackson Hole Chair Powell speech, as the market essentially priced in a much lower chance of a September announcement of taper. And there was no hint of urgency from the Fed leadership here to start or end the QE tapering process. We think the market is currently priced for tapering to be announced by December 20, 2021, and to end sometime in the second or third quarter of 2022. The first 25 basis point Fed rate hike is priced to occur in March, 2023. Now, I would say the timing and pace of taper seems very much in line with what the Fed is communicating, and our forecast as well that Jim just described. We are less convinced that the Fed will be able to hike by early 2023 though. The bar to hike is much higher, but we think we need to see inflation readings moderate for the market to really push out the timing of the hiking cycle beyond this early 2023 frame. But ultimately, I want to highlight that it's economic data that we think is going to matter more for markets than Fed policy in the near term. There are concerns that growth is slowing at precisely the exact time as the Fed is tapering. And so this is probably a good time to bring in Jim again to talk about the economy. Jim, let me ask you, how are you forecasting the economy? I want to ask you about both growth and inflation-- the Fed has a dual mandate. And if you can give your outlook for the rest of this year, but also next year as the Fed presumably tapers and then starts to get ready to start hiking.

JIM O'SULLIVAN: Starting on the growth and the associated employment side, the numbers have certainly been incredibly strong, but they have been boosted by the reopening process and massive fiscal stimulus. So some slowing is inevitable, we would say, as those boosts fade. And the latest COVID wave appears to be causing some slowing as well. I mean, even if the economic fallout has progressively been smaller with each COVID wave, as we've seen them come. Similarly, on the inflation side, we believe slowing is inevitable as the bottlenecks associated with booming growth ease. Part of that process could be a better supply/demand imbalance in the labor market. There's various factors that have been discouraging people from coming back into the workforce ease. Net net we expect the trends and growth in employment to stay fairly healthy, but for the pace to clearly slow significantly in the year ahead. For real GDP, growth was up around a 6 and 1/2% pace in the first half of this year. We expect something like that again for the third quarter. We've got 7%, with maybe a bit of downside risk to that number. But after that, we do have a slowing to 4% in the fourth quarter-- obviously, still pretty strong. And then 3% in the first half of next year, and then down to 2% by the time you get to the second half of next year. A big part of that pattern is the expectation that fiscal stimulus will fade to the point of actually being contractionary on a change basis next year. Now, in turn, we expect the inflation numbers to slow pretty sharply as we get into 2022, with the core PCE series, the key trend indicator for the Fed, slowing from what's a 3.6% reading year over year right now, and obviously that's well above the Fed's 2% goal for inflation over time, to just 1.8% at the end of next year. I'll add that that inflation number, in particular, will be key to whether the Fed can hold off for a while on rate hikes after the tapering process winds down.

PRIYA MISRA: Thank you, Jim. Let me give a rates market assessment of the macroeconomic picture, and then talk a little bit about how we forecast interest rates going forward. Let me start with inflation. Now, I would argue that the inflation-linked, or TIPS, market here is pricing in transitory inflation, which is very much in line with the Fed, as well as Jim's view that inflation prints are likely to decelerate from current levels. On growth, one could argue that risk assets are pricing in a strong economic recovery. But then you could argue that the level of rates is low, so is there some confusion there between what risk assets are telling us and what rates are telling us? If we look a little bit deeper into the pricing of rates, the market is pricing in the first hike not that long after tapering ends. But here's the key point. The market's pricing in a very low terminal rate of less than 1 and 1/2%. It's an extremely shallow hiking cycle that the market's pricing in. And what that tells us is that the market is optimistic about growth in the near-term, but concerned about longer-term growth prospects, and really doesn't believe that the Fed can hike too much. And so an accommodative interest rate environment remains, and that tends to be positive for risk assets. Now, I think it's a word of caution here that the last hiking cycle ended with the Fed funds rate at 2 and 1/2%. So it's going to be very interesting to track as the Fed begins the exit. If the economy can weather the tapering process and the Fed can start the hiking cycle, the market should start to price in a higher end point of the hiking cycle. Now, we don't expect 3% or 4% end point of the hiking cycle, but a 2%, 2 and 1/2%, end point of the hiking cycle is quite possible, and that has implications for longer-term rates. We are looking for higher treasury rates all the time, because we think that the economy will remain resilient to the recent Delta surge. We think we get additional fiscal spending from Congress. And we think the Fed tapers and ends its asset purchases without any meaningful weakening in the economy. And therefore, we're forecasting 175 on the 10-year by year end, and rates continuing to rise through the course of the year-- moderate increase, but getting a little bit above 2% by the end of next year. But Jim, let me now ask you a little bit about fiscal policy, since that is one of our key drivers for forecasting higher long-term rates. Congress, I know, has been debating the bipartisan infrastructure package, as well as the Democrat-only $3 and 1/2 trillion package. What do you expect passes by year-end, and then what's the economic impact?

JIM O'SULLIVAN: In total, Democrats are proposing a little over $4 trillion in spending. There's the $3 and 1/2 trillion package, as you mentioned, which is expected to be Democrat-only votes and pass through the reconciliation process. There's the bipartisan infrastructure package, which is a little over $500 billion, it looks like, in terms of net new spending. So it's a little over $4 trillion in spending that's being proposed. Now, the legislative process still has a long way to go. But in the end, we do expect Democrats will get much of-- not all, but much of that $4 trillion enacted. Now, in terms of thinking about the economic effects, certainly $4 trillion is a lot of money. It's equivalent to 20% of annual GDP. But in terms of thinking about the economic effects, it is important to recognize that what's being proposed is spread over 10 years. Now, in contrast, when you look at the $5 and 1/2 trillion or so of COVID stimulus that's been enacted over the past year and a half, that was much more front-loaded. It was largely front-loaded in terms of its spend-out into fiscal '20 and fiscal 2021. There will also be fairly sizable tax offsets, tax increase offsets. The net result we feel will be a pretty sizable drop in the deficit as you get into 2022. We expect the deficit to drop to around $1.5 trillion in fiscal 2022, which is obviously very large still historically, and it's around 7% of GDP. But that would be down from around $3 trillion, or 13% of GDP, in fiscal 2021. Now, in turn, that means a fading of fiscal stimulus to the point of a drag on growth as you get into next year, which is, again, key to our view that growth will be a lot slower in 2022 than it has been and we expect will continue to be in 2021. And even that is allowing for some spend-out of the earlier stimulus payments by individuals with a lag. A lot of that earlier stimulus for sure was saved, and we do expect some spend-out over time. But again, the net of all this, we do think fiscal policy, if anything, is fading to the point of being a bit of a drag as you get into 2022.

PRIYA MISRA: Thank you, Jim. Let me follow up on Jim's point on the deficit. Even though we expect this fiscal package with some deficit impact, there is a meaningful decline in the deficit next year compared to this year. So that has treasury supply implications. We expect treasury auction cuts in November for three quarters spread across the curve, a little bit more in front-end auctions, since those auction sizes tend to be larger. However, I will flag that supply numbers are very large, especially as the Fed tapers, and that is a key aspect of a higher interest rate call going forward. I also want to bring up the debt ceiling, which will be hit sometime in October or November of this year. Recall there was a big market event in 2011, when the US got downgraded. But this time around we don't see any political will to actually default on treasury debt. We expect Congress to either suspend or actually raise the debt limit by the time we get to that drop-dead date. So I think there is market nervousness, but we don't expect it to be a market event as we get closer to that drop-dead date. Another topic I wanted to quickly touch on was Fed leadership change. Chair Powell's term is up at the end of Jan next year. Jim, do you expect him to be renominated? And when do you think we'll actually hear whether he will be or not-- renominated?

JIM O'SULLIVAN: Will he be renominated? We'd say probably yes. And certainly if he is renominated, I don't think there's much doubt that he'll be confirmed again by the Senate. And cynics might suggest that his relatively dovish Jackson Hole speech last week was to help his case for renomination. And we wouldn't say that was the motivation, but it probably did help his case nonetheless, in contrast to if he had been very hawkish. I mean, in assessing the politics of this, I mean, in general, Democrats do appear to be pretty happy with his performance on monetary policy, which, of course, is generally seen as the main function of the Fed. I mean, I think people are fairly confident that he won't cut the recovery short by raising rates too soon or too aggressively. But the Fed also plays a key role as a regulator of banks, kind of separate from its role in terms of monetary policy broadly for the economy. And certainly, the progressive wing of the Democratic party apparently, including the very influential Senator Warren, is pushing for someone who will be much tougher on the banking system. In the end, we expect he will get reappointed though. At the same time, we expect the two vice chair seats-- there's the board vice chair spot, held by Clarida right now; and the vice chair specifically for supervision, Quarles right now-- those two spots will most likely will be filled by new people, and that will be part of the package. Now, currently, Governor Lael Brainard, who has been harder on banks in her time at the Fed than most of her colleagues seems like a good bet to fill one of those slots at least. Now, there's also one open seat on the board that still needs to be filled. So all in all, we'd say for monetary policy, at least, the end result is likely to be a Fed that's even more dovish than it is now, even assuming no change in the chairmanship. Now, as for when, Powell's term doesn't end until February 5, so there's still some time for sure, and the president is arguably preoccupied right now with Afghanistan. But we'd say most likely we'll hear of the renomination by November at the latest. We'd say probably sooner. That would certainly give the Senate time to have the confirmation hearing before the end of the year. But we'll see. But again, we do expect to hear it, and by November at the latest.

PRIYA MISRA: This is another source of uncertainty for the market, especially as the Fed exit begins. Also, I would argue it's always tough for the market to price in any change in leadership. So the sooner we know about who will be the next Fed chair, I would argue, the better it is. And finally, I want to end with risks to the outlook. Jim, in your view, are risks skewed to the upside on inflation, or the downside on growth due to the surge in the Delta variant?

JIM O'SULLIVAN: Well, I mentioned earlier the pattern where each successive COVID wave-- and there have been four main waves now-- seems to have had less economic fallout, in terms of the growth impact than the previous wave, as the appetite and arguably the need for shutting down activity has faded, even more so now that a large-- not large enough, but large-- share of the population is vaccinated. Having said that, we are clearly seeing some fallout from the latest wave. And as mentioned earlier, growth is inevitably slowing as the boost from reopening and fiscal stimulus fade as well. That's part of the reason we expect upcoming employment numbers to disappoint a bit, helping the case for the Fed to kind of hold off a bit more on tapering. And again, that's even as we expect trends to stay pretty healthy over the next few months. The bigger risk on the growth side, arguably, is some new variant at some point for which vaccines are much less effective. Now, hopefully, that won't happen, but I mean, there are risks for sure. On inflation, there's a risk that the pickup is not as transitory as Fed officials and we believe it is, as the pickup effectively could feed on itself and become self-perpetuating through higher wage demands and inflation expectations. Again, that's not our forecast. But it's certainly something to watch for.

PRIYA MISRA: To add to Jim's point on risks, I do want to flag global growth risks, and that has significant implications for US treasury rates as well. While we are looking for higher treasury rates over time, as I discussed earlier, we have seen a recent pickup in foreign demand for treasuries. We've seen it in the auction allotment data in the August auctions. And even though we don't have high frequency data that can pinpoint exactly which foreigner is buying, we think this could have been both China, as they invest their intervention dollars, and Japan, as they are looking for the highest yielding developed market debt out there. Continued strength in the foreign bid could mute the rise in rates. And thus, we'll be watching for signs of a weakening global economic outlook that can create the demand, which can essentially then offset Fed tapering. We actually saw this dynamic in 2014, when the Fed was tapering last, where there was this weaker European Economic growth, and that brought in significant demand for treasuries. And rates actually fell throughout the year, despite Fed tapering. For now, we think that slowing global growth and the demand from foreigners can moderate the extent of the Treasury market sell-off. But if that intensifies, if that bid intensifies, it could actually prevent the move entirely. So we'll be monitoring global growth and FX intervention flows very closely. With that, I think I will wrap it up. Jim, I would like to thank you a lot for your time today and for sharing your insights. It's going to be a fascinating and exciting time in the macro world over the next few months. So thank you for helping us navigate what lies ahead. And I want to wish all our listeners the very best.

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