Notes From Underground: Brainard Delivers a Very Significant Speech

Tuesday, FOMC Governor Lael Brainard delivered what I deem to be a very important speech, which spoke to the necessity starting to shrink the balance sheet while halting further interest rate increases. The speech, titled, “Cross-Border Spillovers of Balance Sheet Normalization,” is packed with insight into FOMC thinking reminiscent of the powerful speeches of former Fed Vice Chairman Donald Kohn. I have noted that Brainard is Yellen’s confidant (mere conjecture on my part) similar to how Kohn served as Greenspan’s consigliere, providing great insight into FED policy. Governor Brainard puts forth the reasons for HOLDING fed funds steady while beginning the task of balance sheet shrinkage. Important points to consider:

1. Raising policy rates and reducing central bank balance sheets–appear to affect domestic output and inflation in a qualitatively similar way. This means that central banks can substitute between raising the policy rate and shrinking the balance sheet to remove accommodation;

2. Is there a difference between conventional policy hikes or shrinking the balance sheet on cross-border spillover effects? “Most prominently, the exchange rate may be more sensitive to the path of short-term rates than to balance sheet adjustments, as some research suggests,” (Stavrakeva and Tang, 2016). This issue is what I have discussed for eight years in NOTES FROM UNDERGROUND. Foreign exchange rates are more sensitive to the short-end of the curve than the long-end. A flattening curve has historically been positive for a currency as the interest rate market is signalling that the central bank is too tight for economic conditions. (Brainard cites the example of the FED‘s Operation Twist in the early 1960s.)

If a similar amount of tightening is achieved through the balance sheet reduction “… while keeping the POLICY RATE unchanged, the exchange rate would appreciate to a SMALLER degree, reflecting the lower assumed sensitivity of the exchange rate to the term premium than to policy rates.” Governor Brainard further supports this view by noting that other countries would not have to act as swiftly to raise rates in response and therefore allow other nations to pick up the slack if the U.S. economy was to slow down. Also, in the case of a managed exchange rate, she cites China in 2015-16 as China responded to the incipient rise in U.S. fed funds rate by squeezing liquidity and depreciating the YUAN.

3. If different monetary regimes are pursuing different policies in trying to contain demand shocks, the cross-border impact on the nation using interest rate policy versus balance sheet shrinkage in the other will probably result in greater foreign exchange rate movements. Brainard notes that the “… downward pressure on term premiums around the globe, especially in those foreign economies whose bonds were perceived as close substitutes.” Certainly this speaks to the BUND/U.S. 10-YEAR NOTE correlation. In this regard the Brainard suggests that the BOJ and ECB present programs provides an opportunity for the FED to reduce the balance sheet without as much disruption as the fungibility of global markets will provide some support to U.S. term premiums.

4. Inflation for Brainard will remain very important. She said, “I will want to monitor inflation developments carefully, and to move cautiously on further increases in the FEDERAL FUNDS RATE, so as to help guide inflation back up around symmetric target.”

I fully expect Chair Yellen to speak to this in her testimony this week. If I am right, the yield curve OUGHT to steepen further. The 2/10 curve closed at 98 basis points Tuesday after holding support levels. The SPOOS and NASDAQ should fine near-term strength as markets believe that FED FUNDS INCREASES ARE ON HOLD. Commodities should return to supply/demand fundamentals and the precious metals OUGHT to repel fears of rising short-term rates. Also, emerging markets should breathe a sigh of relief.

There is much to contemplate in Brainard’s speech, but if she plays Jiminy Cricket to Janet Yellen expect the Fed chair to support this outlook. The FED seems to have been shaken by the recent severe flattening in the yield curves. Other political factors such as the White House tweets and buffoonery cannot be accounted for in an algo-driven world. But I believe that Brainard did more to impact markets than the e-mails of Donald Trump, Jr.

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9 Responses to “Notes From Underground: Brainard Delivers a Very Significant Speech”

  1. john bougearel Says:

    Sticking with Yra’s observation that a cessation of rate hikes in 2H2017 will lead to a steepening of the yield curve, it just so happens that the behavior of the long term yield curve confirms his insight. When rate hikes ceased in Nov 1980 to Jan 1981, March-May 2000, and again in Dec 2006, the yield curve steepened.

    The last two steepening of the yield curve events in 2000 and in 2007 led to bear markets in US equities. In effect, higher long term yields will probably have a dampening effect on one of the biggest drivers of the bull market in equities since 2009 – that of stock buyback programs.

    And along with a steepening of the longer term yield curve, we ought to see a change in the long term secular bear trend in US treasury yields (see upcoming 10 yr yield post on how that might happen).

    -email me for a copy of the full post Yra

  2. Ronald Ferrill Says:

    Guess I’m an ingenue because it seems pretty obvious that managing the balance sheet is likely more organic to the market and has sticking power (buy and sell) versus decrees of rates, where the market has scoffed before and did what it will.

    On another note, totally disjointed, but very pertinent to the world we live in, I am within 15 pages of the end of “As a Driven Leaf” by Milton Steinberg, first published in 1939. It has provided the cynic in me more insight into the torturous nature of mankind with his insidious will to power and how it can destroy the goodness of hearts. It has hardened my belief that God and Faith are required more than ever, even though this book was written about Judaism in the time of Hadrian, and written during the time of Hitler. We are in a world now, where we distract ourselves (the big we, not necessarily those of us in Yra’s band and others Jew, Christian, others of peace and goodwill), with strictly worldly pleasures and pastimes, never looking at this world as our gift from a Father, and ourselves as stewards, nurturers by nature.

    Highly recommend the effort and perhaps a hurt heart to read this wonderful book. Chapter XVIII was the point of it all for me.

    So, let us not confuse deliberate decrees with the organic nature of markets. Mere bureaucrats will do as they will, and markets will do their own thing based upon the vagaries and designs of the players.

  3. Pierre Chapuis Says:

    Can somebody post a link where I can see the 2/10 curve?

  4. David Richards (@djwrichards) Says:

    Another fantastic blog post! Indeed, Ms Yellen dialed back rate hikes as in her prepared remarks for the US Congress, she said that rates won’t have to rise much to get to neutral and further hikes hinge on inflation, which is currently running below their goal. Her previous “transient lower inflation” was apparently transient, haha.

    These are not the words of a central banker who wants to do the right thing and normalize rates like they should have already years ago. So whether due to its dovish central bank or dysfunctional federal government, the US dollar and US assets remain a SELL, if you haven’t already sold. There continues to be better pickings abroad, at least for this year.

    Interestingly, although Euro initially surged to almost 1.15 on Yellen’s dovish opus, Euro then sank bigly to as low as 1.138, perhaps on worries Draghi might next back pedal like Yellen just did?

  5. Recoba Bacci Says:

    Yra thank you for linking to that speech it was highly informative. Can you please explain why If a curve is flattening, thus signaling that policy is too tight why is that positive for currency?
    Thank you

    • Yra Says:

      Recoba–thanks for your support.I will answer this question as a full blog but in a short answer and in line with Brainard’s speech a flattening curve signals that short rates are too high relative to the underlying fundamentals of the economy—this is attractive for flows investors as they lock up higher short term rates as the central bank will react to predicted slowdown by cutting rates at some time in the near future—the classic example of this was in 2007-8 when the 2/10 u.s. curve actually inverted

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