Fed Chair Jerome Powell is expected to speak at the Economic Club of New York later today, and will probably deliver the last substantive comments from a Fed official before the next FOMC meeting. He will have to walk a tightrope as markets are jittery about the currency market. On the one hand, it’s seen as unlikely that the Fed will hike at the next meeting, but will have to retain its credibility about the possibility of hiking in December.
Whether the Fed will actually go through with that final hike is still a matter of debate between the Fed and the markets. Meanwhile, bonds are showing that there are some serious underlying concerns with the US economy and financial system. Noted economist Mohamed El-Erian recently wrote an article in the Financial Times warning that the US bond market is losing its strategic footing. That could spell consequences not just for the dollar, but the global economy. How Powell handles the situation could be pivotal for the markets as we head into the blackout period before the next policy meeting by the FOMC.
Cracks: Superficial or Structural?
Powell’s speech comes at a crucial moment for the financial markets. US bond yields have spiked to multi-year highs, propelling the dollar forward. A combination of factors is forcing the US government to pay more interest on its debt, which could further destabilize the bond market. The large amount of bond issuance at a time when the Fed is selling bonds, and foreign investors are reluctant to buy has created a demand problem for US debt. On top of that, the traditional largest buyers of US debt – banks – are sitting on large unrealized losses already from bonds that they bought when yields were low. They are reluctant to buy into the market.
Meanwhile, the US economy has unexpectedly outperformed. The Fed’s GDP Now forecast for the Q3 annualized economic growth figure is to top out at 5.4%. This is a level of activity that encourages inflation, and CPI change has been accelerating again over the last few months. Although the core rate – excluding food and energy – has continued to come down slowly, the trend would likely make the Fed uncomfortable about ending its hiking program.
Something’s Got to Break
The Fed has had a fairly fast pivot from focusing almost exclusively on inflation to suddenly worrying since the summer that the economy might not grow. Higher bond prices threaten to tip the economy over into a recession – which could heighten the problems for the bond market. Slower economic activity means less revenue for the government, which will need to issue more debt to compensate, which means yields would go even higher. Banks and institutions that hold treasuries could experience even more losses. This could become a further problem if the recession means savers have to withdraw funds from banks, forcing those banks to sell off treasuries in their reserve.
The banking crisis in March was the result of higher interest rates. The Fed is likely to want to be cautious about not recreating that issue with more rates. But inflation remains persistently high, and any sign of buckling could cause prices to rebound anew. Therefore, the focus of Powell’s speech is likely to be on how he tries to navigate these two issues, keeping the door open for more hikes, but trying to reassure the market that interest rates won’t get out of hand.
