On Hold Is Not Neutral When the Next Move Is a Hike

On Hold Is Not the Same as Neutral

The June inflation report took a July rate hike off the table and the Fed is expected to stay put. This is reported as a pause which is accurate and incomplete

A pause tells you what happens at the next meeting. It doesn't tell you which way the committee is leaning and that second factor governs almost everything else. A central bank that stays put because it thinks it's finished is in a completely different position than one that stays put because it's waiting for a reason to raise

Right now it is the second. The market's own pricing foresees an increase at the end of the year rather than a decrease meaning that the current level of rates is a floor and not a ceiling

The Asymmetry That Changes Everything

Under a cutting bias a weak economic number is doubly good news. It brings relief closer and lowers the discount rate applied to each future cash flow. Bad news drives up asset prices which is the pattern most people have internalized over the past two decades

Under a hiking bias the arithmetic is different. A weak number does not bring a cut closer because a cut is not what is contemplated. What it does is take away an increase which is a smaller and less valuable thing. The advantages of bad news are limited to what the increase is worth while the disadvantages of a strong number are not limited because a good enough number can add increases that no one has valued

This is why a pause in an uptrend looks tighter than the level of rates alone suggests. Every data release is a one-sided risk and portfolios that were built under the assumption of a bailout of weakness carry unnamed exposure

The Bond Market Agrees

The clearest independent read on the stance comes from the two-year Treasury bond which yielded 4.33 percent in late July

That maturity is useful because it serves as the market's average estimate of where the policy rate will be over the next two years. When investors expect a series of cuts that yield falls well below the current policy framework because the average of a downward path is lower than its starting point. None of that is happening. The two years are close to where the policy already is

So the bond market isn't at odds with the committee and isn't waiting to be bailed out. It has taken the guidance at face value and priced a policy rate that stays more or less where it is. For anyone whose plan quietly boasts cheaper money next year that's the number to watch because it's a live price paid by people with capital at stake rather than a forecast posted by someone with none

Why One Good Print Does Not Settle It

The June figure landed at 3.5 percent on the headline gauge the friendliest figure in more than twelve months with cheaper crude doing most of that work after a ceasefire removed oil's risk premium

A committee with a bullish bias will discount it heavily and it should. The purpose of policy is to affect demand and a drop in crude oil prices affects the price level without saying anything about demand. If the energy improvement is reversed the impression is reversed with it and the committee will have fallen into an inflation problem that it never really solved

So the reaction function here is also asymmetric. A good energy-driven headline number buys a break. You don't buy a part because it didn't prove anything about the underlying trend. On the other hand a bad energy-driven headline number is harder to dismiss because a central bank that ignores rising prices on the basis that they are the wrong kind of prices risks creating the expectations problem it aims to prevent

The Credibility Constraint on a New Chair

Any committee under a president who has recently assumed office operates with a constraint that does not appear in any model and that is that its reaction function has not yet been demonstrated

A long-lasting chair has a record. Markets can watch how that person responded to a surprise and value the next person accordingly which means communication is part of the job of politics. A new president has said things but not done them yet so the market has to price a broader spread around each decision until the record exists

The practical effect is that a new committee is under pressure to establish the reaction function early and the cheapest way to establish an anti-inflationary reputation is to be visibly unwilling to claim victory. That pushes to sustain an increase longer than the data alone would justify and to adopt language that keeps an increase alive even when no one expects it

None of that is a criticism. Reputation is a genuine political instrument and a committee you believe in can accomplish with words what a disbeliever has to accomplish with rate increases. What it does mean is that reading the current position as a pure response to data overlooks some of what's going on

The Cost of Being Wrong Runs One Way

The deeper reason why a bullish bias persists after the numbers improve is that the two available errors are consequently not symmetrical

If they tighten too much the result will be a weaker economy higher unemployment and a recession. This is a serious and recoverable outcome. The tools to fix it are well understood work reasonably quickly and have been used by all central banks

If they ease too soon inflation will accelerate again from a level already above target. The cost of fixing that is not another year of the same policy. This is a much more pronounced subsequent tightening imposed on an economy that has meanwhile planned under the assumption that the fight was over. There is a well-documented historical case of exactly this pattern in which premature easing was followed by a second wave of inflation and a much harsher response

Faced with a recoverable error on the one hand and an aggravating one on the other a committee that is unsure will lean toward the recoverable error. That inclination is the bullish bias and explains why it can survive several good inflation numbers in a row

What a Floor Under Rates Does to Everything Else

The practical consequence of a bullish bias really has nothing to do with the next quarter point. It is that the cost of money has a floor underneath it and a floor changes the way all other decisions are made

For a company with maturing debt the calculus used to be whether to refinance now or wait for better terms. With an upward bias waiting has a cost and no expected benefit so refinancing is brought forward and treasurers pay off the debt at rates they don't like because the alternative is worse. This is visible in issuance patterns long before anything the Fed says

For someone who values ​​a long-lived asset the discount rate is no longer a temporary inconvenience. A company whose profits come mostly in the distant future is worth dramatically less at these rates than at those that prevailed for most of the last fifteen years and a bullish bias eliminates the argument that it can be waited because relief is yet to come

For households the floor is the housing market. A mortgage rate that could fall makes waiting rational and a mortgage rate that could rise makes waiting costly. Which of those two states people think they are in determines transaction volumes more than the level of the rate itself

And for anyone holding cash the floor is the good news in all of this. Short-term government securities yielding well above four percent are a genuine alternative to taking risk which is a condition that did not exist for most of the previous cycle and which raises the bar that every risk asset must liquidate

What Would Actually Change the Call

Since an energy-driven print doesn't do this it's worth being specific about what would

Core inflation falls for several consecutive months since it is the measure that the committee is really targeting in practice and it is the one that is not flattered by crude oil

Evidence that the labor market is relaxing steadily and not all at once because wage growth is the mechanism by which inflation becomes persistent rather than transitory

Inflation expectations remain anchored which is what a central bank really stands for. A committee will tolerate a bad impression with anchored expectations and will not tolerate a good impression with drifting expectations

And on the other hand a real break in something financial which changes the calculus immediately. Central banks that are worried about inflation stop worrying about inflation the moment a large institution is in trouble and that has been true in every cycle

How I Read a Pause Like This

I stopped treating meetings as events. In a cycle with clear direction meetings matter because the question is at what speed. In a biased pause meetings are mostly non-events and the data release is the whole story as each one changes the probability of a move that is not currently expected

I also try to take asymmetry into account when reading market reactions. A rally on weak data in this regime doesn't mean the market is holding a bailout. It's about the market eliminating a rally it had partially priced in which is a much smaller thing and should produce a much smaller move. When the move is big something else is going on

And I take the language of pause less seriously than the language of risk balance because the former describes one meeting and the latter describes the reaction function that governs the next ten

The Case That the Bias Is Theatre

The main risk of all of the above is that it is assumed that the bias declared by the committee is the real one

A central bank that has quietly finished raising rates has every reason to keep saying it might raise them because the expectation of a tightening does part of the job of doing so at no cost. If that's what's happening then bullish bias is a communication strategy rather than a forecast and positioning for a hike that never actually came would be a costly mistake

There is no way to distinguish them from the outside which is the goal of the strategy. What can be said is that the December price in the market is itself a probability rather than a prediction and a market that has the next move as an increase later in the year is also a market that has priced in a substantial possibility of no move occurring

The Bottom Line

The Fed is on hold and the next move is more likely to be up than down making this a different environment than the environment most portfolios were created for. Good news hurts bad news helps only a little and a single figure of inflation driven by falling energy prices doesn't change a reaction function that is deliberately reluctant to claim victory. The two-year note near the policy rate says the market doesn't expect any bailout the asymmetry of the two possiblePolicy errors explain why the committee leans the way it does and what's worth watching is underlying inflation and expectations rather than the headline figure that gets the coverage