Macro Markets Podcast Episode 56: Bond Market Insights from a Fed Insider
Patricia Zobel, Head of Macroeconomic Research and Market Strategy, updates our outlook following the strong market response to the July FOMC decision and jobs report. She also draws from her experience with the Fed’s System Open Market Account, one of its most critical operating functions, to share insights on the Fed’s balance sheet management.
This transcript is computer-generated and may contain inaccuracies.
Jay Diamond: Hi everybody, and welcome to Macro Markets with Guggenheim Investments, where we invite leaders from our investment team to offer their analysis of the investment landscape and the economic outlook. I'm Jay Diamond, Head of Thought Leadership for Guggenheim Investments, and I'll be hosting today. Now, anyone who thought that July would be a slow news month was dreadfully wrong. Since the June 27th presidential debate, we have seen our election dynamics completely upended. In the economy, after months of upside surprises, we are finally starting to see a cooling in the jobs market and inflation. The FOMC closed out the month with its most recent statement on monetary policy and the July jobs report sparked a sizable risk-off move. In short, it's been an unusually eventful summer and market participants are trying to unpack it all. Now, within Guggenheim's investment process, we rely on our Macroeconomic Research and Market Strategy group to help map out the road ahead. So, it is with great pleasure that I welcome to our podcast Patricia Zobel, who joined Guggenheim Investments earlier this year to lead this group. Patricia has had a stellar career in asset management and at the Federal Reserve. Most recently, she served as manager of the Fed's System Open Market Account, or SOMA, one of the most critical functions of the Fed's operations. In this capacity, she led implementation of U.S. monetary policy and provided insight on global financial markets to the committee. So, we are delighted she is with us at Guggenheim and on the podcast. Welcome, Patricia. Thanks for joining us today.
Patricia Zobel: Thank you. Jay, it's a pleasure to be here at Guggenheim Investments and to be joining this podcast with you.
Jay Diamond: To kick it off, Patricia, let's talk about the FOMC decision. Go through that for us, if you will . What was the decision, and what are your high level takeaways from the statement and the press conference? And how does the job report change that picture?
Patricia Zobel: Well, Jay, it was an important meeting for the FOMC because monetary policy is at something of a turning point. With recent inflation data showing substantial improvement, the Committee's confidence in the disinflationary process has been building. And at the same time, we've seen the labor market has been showing signs of significant cooling, making it more clear that it's time to reduce the restrictiveness of monetary policy. The Committee ultimately left rates unchange at the meeting, but the statement carefully highlighted these developments, stopping short, though, of leaning into any particular timing for easing rates. The chair was a little bit more clear and noted that a September rate cut is on the table and even highlighted that a rate cut had been discussed at the current meeting. So to us, the jobs report last Friday affirmed that downside risks to employment are growing. The report, of course, showed significant slowing in the overall pace of job growth, but for us, more importantly, was the continuing narrowing in the breadth of that growth. Outside of health care and government jobs, private payrolls have been expanding quite slowly in recent months, suggesting in our minds a weakening in private demand for labor. The unemployment rate also crossed an important threshold in the July report, which indicates a greater chance of recession risk. More data will be helpful; as you know, there were some extenuating circumstances like whether in the July report, but this solidifies for us that rate cuts are needed to take pressure off of the economy.
Jay Diamond: Well, thanks for that readout. So, how does this change our house view on the path of Fed rate policy going forward, if it changed at all?
Patricia Zobel: Well, it's a good question. We have been expecting the Fed to ease in September for some time. Even when inflation data was elevated earlier this year, we felt like the details of those reports indicated that price pressures would ultimately abate. And when we looked at the economy more broadly, we saw elevated rates putting pressure on certain sectors, creating downside risks for growth. Friday's payroll report affirms that the labor market is cooling rather quickly, and faster than the FOMC would likely want to observe. For some time, we had two rate cuts penciled in this year with a meaningful chance that more would be needed. This increases the chance to us of three or more rate cuts by the committee this year, so that they can support economic growth. Financial markets are now pricing more than four cuts by the end of 2024. Whether or not that comes to fruition to us will depend on incoming data and whether markets stabilize from here.
Jay Diamond: Do you think that the Fed will take into account the presidential election when deciding to move or not in September?
Patricia Zobel: So my sense, having worked at the Fed for many years, is that they really focus on their mandate of price stability and maximum employment. And when faced with an uncertain event like the election, they tend to take the uncertainty of that event into account, but really don't take into account things like the political environment into their decision making. With downside risk growing, the focus will be on adjusting policy to address the softening outlook.
Jay Diamond: Now, the markets spend a lot of time thinking about the Fed's interest rate policy, and for good reason, but the Fed has other tools at its disposal to put into effect monetary policy, most notably its balance sheet. Now, I want to spend some time on this with you because I believe you're uniquely qualified to help us understand this conceptually as well as practically. So, to begin, tell us a little bit about your role when you were at the Fed running what is essentially the largest bond portfolio in the world?
Patricia Zobel: I worked for many years at the New York Fed, and all of them in what they call the Markets Group. The Markets Group monitors global market developments and, as you said, manages the Fed's bond portfolio on behalf of the FOMC. It was really an exciting place to work and a period of time over which there were extraordinary developments to manage through. So, I grew through different roles in the group, but spent much of the last ten years of my career there working on assignments for the FOMC, examining different policy implementation approaches and helping the fed craft its response to the pandemic stresses. Ultimately, as you noted, I became deputy manager and then manager pro-tem of the Fed's SOMA, which is the Treasury and mortgage bond portfolio. It was a great job working with the FOMC and leading a very talented team at the New York Fed.
Jay Diamond: It does sound exciting. Now, not everyone who's listening has a probably full view of the purpose of the System Open Market Account, so tell us exactly how it functions.
Patricia Zobel: So, I'm glad you asked because the Fed's balance sheet can be very challenging to understand. At a high level, the SOMA is intended to help the FOMC achieve its statutory mandates by implementing the monetary policy stance. The main features of this are laid out in the Fed's statement on longer run goals and strategy. So, the way I like to think of it is, first, the committee's primary means of setting the monetary policy stance is through overnight interest rates, and the Fed directs the desk to maintain the fed funds rate within the target range by supplying reserves through open market operations, which are purchases of assets in the open market. Second, during severe economic downturns, when the zero lower bound constrains the FOMC’S ability to provide accommodation that the economy might need, the committee may also direct the desk to purchase assets to put additional downward pressure on longer term rates. This helps them support the economic recovery by lowering borrowing costs for consumers and businesses. And then finally, the third way they use the balance sheet is on rare occasions when financial market dysfunction threatens the flow of credit to the economy, the Fed may step in to restore market functioning through asset purchases. It may also use other tools as well, like lender of last resort facilities to restore market functioning and support financial stability.
Jay Diamond: Now, with whom are you engaging in these transactions? Is it just the primary dealer cohort or is it the broader market?
Patricia Zobel: That's a good question. For asset purchases for the System Open Market Account, primarily the Fed deals with primary dealers, but what happens when dealers engage in transactions with the Fed, they're also transmitting out to the broader financial market system and engaging in transactions with them as well. So really, the primary dealer system is the conduit through which the Fed interacts with financial markets.
Jay Diamond: These asset purchases to provide accommodation or supporting market functioning are a relatively new tool for central banks, I believe, so really, since the Global Financial Crisis in 2008. So how does quantitative easing help the Fed ease monetary conditions?
Patricia Zobel: So yes, asset purchases were really an innovation during the Global Financial Crisis, when financial stresses created a severe shock to the U.S. economy. Purchasing treasury and agency securities helped the committee put downward pressure on longer term rates by reducing the amount of privately held securities and increasing investor demand for other assets. This lowered borrowing costs at tenors that are important for economic growth, and helped the committee support the recovery after what was a severe shock to the economy. Asset purchases also grow Fed liabilities, in particular reserves which are the most liquid asset for banks.
Jay Diamond: So, when you mention reserves, these are reserves at banks.
Patricia Zobel: Yes.
Jay Diamond: So, talk two seconds about bank reserves and how that all works.
Patricia Zobel: Yes. So, banks hold a range of assets on their balance sheet. One of them is deposits with the central bank, and this provides the most liquid asset for them and provides a buffer for them as they get deposit outflows, because it is a payment instrument that can be used at any time. At one time there were required in excess reserves. More recently, the fed has lowered the reserve requirement level to zero, so now the Fed operates essentially what is a floor, and it supplies an ample amount of reserves so that the Fed's administered rates control the stance of monetary policy. This allows the Fed to control interest rates through a variety of environments, including when it conducts asset purchases. It also supports financial stability by giving banks more of the most liquid asset in the financial system, making them more resilient in liquidity shocks.
Jay Diamond: So, we were talking about QE before, but since June of 22, the Fed has been reversing that process by running off its securities holdings in a process called QT, or quantitative tightening. So how big a factor is QT right now in the fixed income markets?
Patricia Zobel: Balance sheet runoff works in reverse of balance sheet expansion. When the Fed reduces its holding of Treasurys and mortgages, there are more securities that have to be absorbed by the private sector. This can put upward pressure on longer dated yields and tighten financial conditions. There are reasons to believe this effect really isn't as large as it is for quantitative easing, meaning that the upward pressure on rates from QT may not be as large as the downward pressure on rates from QE, but it still supports the tightening of the committee's policy stance. So far, runoff of the Fed's portfolio has gone smoothly, but this is something to continue to monitor closely, in particular in an environment of already elevated Treasury issuance.
Jay Diamond: So, if I follow the logic, if QE adds liquidity to the system, is it fair to conclude that QT reverses that process. So, how does this affect money markets and also factor into the Fed's decisions?
Patricia Zobel: This is something I think the Fed is monitoring really closely. As you noted, as liquidity expands with asset purchases, the interest rates that the Fed pays on its liabilities really help maintain control over rates. This continues to work as liquidity declines as balance sheet runoff continues, unless the system reaches a minimum demand for these balances, at which point rates will rise, reflecting that inelastic demand for Fed liabilities. To date conditions looks stable, but the rate environment is starting to normalize and it bears close monitoring in coming months, really. The committee has said that it will end balance sheet reduction when reserves are somewhat above the level it considers ample, but that level is really uncertain. And so, the Fed will be monitoring money market conditions closely to assess when that occurs.
Jay Diamond: Okay. So let's talk about the pace here. As of May 2024, the Fed has slowed its pace of quantitative tightening, which again it began about two years before, June of 22. So, the Fed's new policy changes and correct me if I'm wrong, include limiting the monthly runoff of its Treasury holdings to a maximum of $25 billion, which is down from $60 billion, and allowing up to $35 billion a month in mortgage runoff. So, when do you believe the Fed will end its balance sheet reduction, and do you believe that once the Fed starts cutting rates or easing interest rate policy, it will continue its QT program, which is by definition a tightening policy?
Patricia Zobel: That's a really good question, how the Fed thinks about its two tools working together. During the prior run off, the Fed stopped balance sheet reduction when it first lowered rates in July 2019. In the current cycle, the chair has refined his communication a little bit on the committee's approach and has said that if rate cuts are just intended to reduce monetary policy restrictiveness, the FOMC is likely to keep balance sheet runoff going until it reaches that ample level of reserves, as we talked about before. But if they are easing to respond to material weakness in the economy, it's more likely that they would end balance sheet reduction as they would not want the two tools working cross-purposes with the balance sheet continuing to gradually tighten monetary conditions while they're trying to ease monetary conditions with the fed funds rate. We see growing risks to a slowing economy, which may pull forward an end to balance sheet runoff.
Jay Diamond: Just in terms of the overall size of the Fed's balance sheet, how small was it in, say, 2008 before QT actually started? Where did it peak and where is it now and where do you think it will end up?
Patricia Zobel: So the balance sheet prior to the Global Financial Crisis was quite small. At the time the Fed was operating a different monetary policy framework. So there were very few reserves in the system on the order of a couple tens of billions of dollars versus being above $3 trillion right now in reserves. Since the Global Financial Crisis, there were several rounds of quantitative easing to respond to a sluggish recovery from the Global Financial Crisis, and then the Fed reduced its balance sheet to something that it believed reflected the amount it would need to operate its monetary policy framework when it expanded its balance sheet quite rapidly to respond to the stresses of that time and the need to support the economy during a severe downturn. So right now, the balance sheet stands at over $7 trillion. We think it will come down a little bit from here, but nothing like to levels that would have been observed prior to the Global Financial Crisis.
Jay Diamond: And I guess it's worth pointing out that the Fed is not alone in terms of global central banks executing policy in this way.
Patricia Zobel: No, advanced economy global central banks have all engaged in quantitative easing since the Global Financial Crisis. And as a matter of fact, the fed is one of the first to have started balance sheet reduction in 2017. You see several advanced economy central banks now reducing their balance sheet sizes, and they're considering their operating frameworks too.
Jay Diamond: Going forward, what will the Fed be watching as it makes plans for its next steps with the policy cycle, and what will you and your team be monitoring?
Patricia Zobel: To date, I would say that the Fed has been able to cool a really overheated economy with limited costs in terms of job losses, and this has been a historically challenging thing to do. With inflationary pressures on a more convincing downtrend and the jobs market cooling, the committee is really watching conditions to ensure that policy doesn't remain restrictive for too long. We're also monitoring the economy closely. In recent months, we had a base case for slower growth this year, but also had significant downside risk to our forecast. Recent signs of a sharper weakening in the labor market affirms in our minds that the risks to economic growth are rising, and that the committee may need to ease more than had been anticipated. We're also conscious that the current environment carries significant other risks and unexpected events that could shift the outlook.
Jay Diamond: Yes. As Anne Walsh said on a recent Bloomberg clip, there are a lot of gray swans out there.
Patricia Zobel: I would agree.
Jay Diamond: Now, the bond market has rallied since the FOMC meeting, not just because of the meeting, there are some data points that came out, but we now have a three handle as of this moment on the 10-year Treasury. and a bull Flattener seems to be in progress. What should bond investors be thinking about right now?
Patricia Zobel: Fixed income yields have been attractive for some time, and there's now potential for rates to decline from here. Even with the significant rally we have seen since the jobs report, it's still a good time to be a fixed income investor. And I think it's an environment that favors active sector and credit selection as the economy is shifting.
Jay Diamond: Well, this has been a great conversation, Patricia. I learned a lot. I really thank you for your time. But before I let you go, what are the main takeaways you would like to leave for our listeners?
Patricia Zobel: So first of all, I would say it's been a pleasure to have joined Guggenheim and really to talk with you here today. I would say that it's an interesting time to be monitoring the macro economy and monetary policy, As the effects of the pandemic fades and the FOMC moves into a new phase of monetary policy. So, it's a good time to be watching events and to be a fixed income investor.
Jay Diamond: Well, my thanks again to you, Patricia, and my thanks to all of you who have joined us for our podcast. If you like what you are hearing, please rate us five stars. And if you have any questions for Patricia Zobel or any of our other podcast guests, please send them to macromarkets@guggenheiminvestments.com, and we will do our best to answer them on a future episode or offline. I'm Jay Diamond and we look forward to gathering again for the next episode of Macro Markets with Guggenheim Investments. In the meantime, for more of our thought leadership, visit guggenheiminvestments.com/perspectives. So long!
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