Tapering, Interest Rates, Debt Ceiling, and China

Last week, the Federal Reserve hinted that a tapering, or winding down of its $80 billion in monthly Treasury bond buys and $40 billion in mortgage-backed bonds, is in its sights. While a near term rate hike is unlikely, the Fed may be eyeing a liftoff late next year.

At his press conference, Fed Chief Jerome Powell said a reduction in bond purchases “could come as soon as the next meeting.” 

Barring a significant economic event, it’s a strong signal that the Fed will announce a plan at its November meeting. Powell added that he expects the bond buys to end in mid-2022.

Since the pandemic began, the Fed’s balance sheet has grown by over $4 trillion, per Fed data.

That’s an enormous amount of cash that has been pumped into the financial system. It has lent support to stocks. Attention is now turning to potential rate hikes.

Connecting the dots

The so-called dot plot is a quarterly graphic released by the Federal Reserve. It is an updated forecast for the fed funds rate for the next three years. As we can see in Table 1, sentiment has been tilting toward a more aggressive posture.

In March, the median forecast suggested no change in the fed funds rate through 2023.

That was before the surge in inflation. Most recently, Fed officials believe a fed funds rate of 1.0% by the end of 2023 is the most appropriate path. 2024 may bring additional rate hikes.

But let’s remember that anything that far out is pretty murky. Much can change over the next year, let alone three years. Besides, even a 1.8% fed funds rate is historically low.

During the last cycle, nine ¼-percentage-point rate increases lifted the fed funds rate to 2.35% without creating undue economic stress.

While most analysts correctly anticipated greater clarity on tapering, many suggested the Fed would stress that there would be a large gap between the end of bond buys and any rate hikes.

In June, Powell downplayed the possibility of any rate hikes in 2023. Last week, he seemed to take a slightly more hawkish posture, suggesting the projections are a “framework.”

Bottom line

The Fed has pretty much met its employment and inflation goals regarding bond buys, and a winding down of purchases is in order. If we look at it through another lens, there are a record number of job openings in the U.S., according to U.S. BLS data. Buying more bonds won’t encourage job seekers.

On the rate front, the Fed is concerned about inflation. Officially, it sees higher inflation this year as “largely reflecting transitory factors.”

But its slightly more hawkish posture suggests it is worried that supply chain bottlenecks could last longer than expected, which raises the specter that price pressures could carry into 2022 or beyond.

Debt ceiling, government shutdown, and China’s Evergrande

The federal debt ceiling must be raised, or the government will lose its ability to borrow sometime in October. As Moody’s Analytics said last week, “The debt ceiling will be raised. Not doing so would be catastrophic for the economy, so this is an extremely low probability event.”

A government shutdown is also a possibility. Historically, a shutdown has had “remarkably little impact on (stock market) performance,” according to LPL Financial and Charles Schwab.

Elsewhere, Evergrande, China’s largest property developer and the world’s most indebted developer, is threatening to default on a mountain of debt. It would the largest ever default by an Asian company, per the Wall Street Journal.

A disorderly default could create big economic problems for China, possibly on the scale of what happened in the U.S. when Lehman Brothers collapsed. Stocks reacted poorly on Monday to the prospect but have since rallied.

For now, it’s primarily a China event, as Powell pointed out in his press conference. He downplayed prospects of contagion but did not dismiss the possibility a default might affect global financial conditions.

Standard & Poor’s says a default is likely, as China has been quiet on a bailout. A disorderly collapse is not in Beijing’s interests. For now, odds seem to favor a more managed transition that avoids a direct bailout, and one that limits economic damage to the country.

If you have any questions or would like to discuss any other matters, please let me know.