Fed plans to buy $60B of T-bills; part of yield curve goes positive

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With talk of a possible mini deal on trade with China and the Federal Reserve announcing it will buy about $60 billion of Treasury bills each month to build its reserves, the 10-year Treasury note was yielding more than three-month bills on Friday for the first time since July.

The Fed said it will start buying the bills “starting with the period from mid-October to mid-November” in addition to “ongoing purchases” reinvesting payments of agency debt and agency mortgage-backed securities.

The Fed will also conduct overnight and term repo operations through January, at least, “to ensure that the supply of reserves remains ample and to mitigate the risk of money market pressures. Term repo operations will generally be conducted twice per week, initially in an offering amount of at least $35 billion per operation. Overnight repo operations will be conducted daily, initially in an offering amount of at least $75 billion per operation,” the Fed said.

Federal Reserve Bank of Cleveland President Loretta Mester, speaking late Thursday, said, “I was certainly sympathetic to the view expressed by the majority” at the most recent Federal Open Market Committee meeting, “indeed, my view of appropriate policy has become more accommodative since last year based on my assessment of economic and financial market developments. But my preference was to leave the fed funds rate unchanged at the July and September meetings. My preferred strategy was to take action only if there were evidence of a material deterioration in the outlook and not merely on heightened risks.”

To determine future moves, Mester said she’ll watch data and “reports from District contacts. I will be particularly attentive to signs that the weakness in investment and manufacturing is broadening, and spilling over to reductions in hiring and household spending, and to signs that long-run inflation expectations are destabilizing. Such signs would point to a material change in the outlook that could warrant policy action.”

She doesn’t foresee “a more serious turndown in the economy,” as growth will stay near trend while the unemployment rate will hold below 4% for the next two years.

The current situation has “some similarities with the period from 2014 to 2016, when the slowdown in global demand, a decline in oil prices, and appreciation in the dollar caused a drop-off in investment and manufacturing activity,” Mester added. “In that period, the overall economy proved to be quite resilient. Nonetheless, the nature of the downside risks this time is different, and it is not too difficult to envision a scenario in which adverse shifts in business sentiment and uncertainty over the outlook cause firms not only to reduce capital spending but also to pull back on hiring, which then causes consumer sentiment and spending to weaken and unemployment to rise, with inflation staying below our target because of weak aggregate demand.”

Declining yields on longer-term Treasuries “suggest that bond investors are putting a higher likelihood on this scenario than they did earlier this year. While lower bond rates have meant lower mortgage rates and some increased activity in housing markets, the overall signal about the outlook from the bond market is a negative one.”

Federal Reserve Bank of Boston President Eric Rosengren said Friday, downside risks have been “elevated” since spring, “but actual economic outcomes … are not much different than what most forecasters expected six months ago or longer.”

He pointed to second-quarter gross domestic product, which was higher than the estimated “potential” rate and, according to forecasts in the latest Summary of Economic Projections, should remain near potential.

Consumers have been fueling the economy, he said, “bolstered by plentiful jobs in tight labor markets, strong growth in personal income, and increases in household wealth due to rising prices of assets like stocks and homes. An important question remains whether consumption can continue to offset the negative effects of trade problems and slower foreign growth.”

Since “monetary policy is already accommodative,” Rosengren said, “my view is that policymakers can be patient and continue to evaluate incoming data before taking additional action. My forecast for the economy does not envision additional easing being necessary. However, should risks materialize and economic growth slow materially, to below the potential rate, I would be prepared to support aggressive easing.”

He noted rates are “not that far from zero,” which gives the Fed “limited scope to lower rates in the event of a downturn. That limited policy space – which some see as reason to ‘keep powder dry,’ and others as reason to act early – should also figure into the Fed’s determination of appropriate policy today.”

The FOMC as a group sees the need for additional accommodation, said Stifel Chief Economist Lindsey Piegza. "While the Fed has described recent rate cuts as an insurance-style move or a mid-cycle recalibration, as the economy continues to need further stimulus it will become incredibly difficult for the Fed not to recognize the end of the credit cycle is closer than previously anticipated,” she said. “And furthermore, that the next round rate cut is to simply support a faltering economy and not any type of mid-cycle adjustment or preventive measure."

The Fed is apt to start using forward guidance, said Ed Al-Hussainy, senior interest rate and currency analyst at Columbia Threadneedle. “[L]ook for secular factors (falling neutral rate and rising risk of hitting zero lower bound in the near term, slow productivity/capex, structural inflation shortfall below 2%) to dominate cyclical data,” he said. This “implies [an] end to flattening/inversion bias to the curve and increases probability of steepening led by the front end yields repricing lower/an aggressive Fed easing cycle.”

While “multiple Fed speakers over the past couple of weeks have made a coordinated push to underscore that the economy is ‘in a good place,’” he said, “This should not inspire comfort for investors since this narrative is largely priced-in. What matters is the rate of change of the growth outlook, and on that front we have hit a wall.”

The Fed’s outlook, which projects fewer rate cuts than does the market, “doesn’t jibe with the current mix of expected growth and inflation,” said Sebastien Galy, senior macro strategist at Nordea Asset Management. The Fed may want “to wait and see the impact of past and current easing on the economy before it takes its next measures.”

If this is a mid-cycle correction, Galy said, there will be one more “rate cut and then at least three months on hold to see how the data starts to react. Anything less would be noise as it takes about six months for the economy to start correcting.”

Data
Import prices gained 0.2% in September after a 0.2% decline in August, the Labor Department said Friday. Petroleum prices jumped 2.3% in the month. Excluding those, prices would have dipped 0.1%.

Export prices slid 0.2% in the month.

Economists polled by IFR Markets expected import prices to dip 0.1% and export prices to be flat.

The University of Michigan’s preliminary October consumer sentiment index rose to 96.0, its highest reading in three months from the final September 93.2. The current conditions index rose to 112.4 from 108.5 in September, while the expectations index gained to 84.8 from 83.4.

Economists expected 92.0 for the main index, 108.0 for the current conditions and 82.1 for the expectations index.

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Monetary policy Economic indicators Consumer sentiment index Eric Rosengren Loretta Mester Federal Reserve Federal Reserve Bank of Cleveland Federal Reserve Bank of Boston FOMC
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