Monetary Policy Changes

If long-end bond yields spiral out of control, the Fed could start injecting liquidity again: a step-by-step guide of how it works. When a few weeks ago 30-year bond yields briefly flirted with the 5% level, the Fed's Collins released an interview stating that ''the Fed is absolutely ready to stabilize markets''. To stabilize the bond market, they would ''inject liquidity'' through operations like the LSAP - Large Scale Asset Purchase or QE. Central Banks create bank reserves when they perform such operations. Bank reserves are often referred to as ''Liquidity''. When Central Banks engage in liquidity creation, they do that in the hope that it activates the so-called Portfolio Rebalancing Effect. To understand this, let’s start from what QE does to the balance sheet of a commercial bank - take a look at the chart below. Following the GFC, regulators forced banks to own more HQLA (high quality liquid assets) to meet depositor outflows. Bank reserves and bonds qualify as ''HQLA'' as they are liquid enough to be converted in cash to meet potential outflows quickly. But banks are not indifferent between owning bank reserves and bonds, and especially if the amount of reserves grows dramatically as a result of QE. Bank reserves are a zero-duration and low-yielding instrument which can be suboptimal to own in big sizes especially if compared with bonds which offer higher returns and duration hedging properties. And this is when the Portfolio Rebalancing Effect kicks in. Once QE starts, Central Banks take away bonds and inject new reserves in the banking system. Loaded with suboptimal reserves, banks will try to switch back the composition of their portfolios towards more bonds. They will bid up safer bonds first, and bid up riskier bonds later when the hunt for returns intensifies. This will kick in a virtuous cycle of low volatility and a hunt for riskier assets: the Portfolio Rebalancing Effect in action. Summarizing: 1️⃣Central Banks expand their balance sheet and purchase bonds 2️⃣Commercial Banks are on the receiving end of QE, and hence their portfolio composition tilts towards more reserves, and less bonds; 3️⃣But reserves are sub-optimal to own compared to regulatory-friendly bonds, and hence they look to rebalance their portfolios; 4️⃣They start buying the very same bonds QE is buying, hence suppressing volatility further and compressing credit spreads; 5️⃣Asset allocators and investors across the world are more and more encouraged to take additional risks in their portfolio, supporting the flow of credit and capital. Does the Portfolio Rebalancing Effect make sense to you? 👉 If you enjoyed this post, follow me (Alfonso Peccatiello) to make sure you don't miss my daily dose of macro analysis.

✨ The EY EY-Parthenon Macroeconomics Team is excited to present the July 2024 US Executive Briefing! 🧭 The US #economy is decelerating moderately as we pass the midyear point. Nothing alarming, but labor market momentum is cooling with initial claims for unemployment on a gentle uptrend, the unemployment rate creeping up past 4%, payrolls gently slowing, hours worked moderating, and wage growth easing. 💸 With real disposable income growth having slowed to a modest pace, #consumers are favoring prudence over exuberance. Lower and median-income households with higher debt burdens and weaker savings buffers are showing more price sensitivity and discretion in their purchases while higher-income families are still spending relatively freely. 🏢 #Businesses are also being more judicious with their hiring and investment decisions while offering discounts and incentives to draw more price-discriminating customers. The housing market remains largely frozen with limited supply and depressed affordability constraining demand. 🔮 Looking ahead, cost fatigue and general macroeconomic uncertainty around the elections, policy, and geopolitical developments will keep expectations in check. We foresee: 1️⃣ Real #GDP growth averaging 2.3% in 2024 and moving slightly below potential at 1.7% in 2025. 2️⃣ #Unemployment rate rising further toward 4.3% while job growth slows below trend. 3️⃣ Fed’s favored #inflation gauge, the deflator for personal consumption expenditures (PCE), ending the year around 2.5% y/y. 4️⃣ Two 25bps #Fed rate cuts before year-end, followed by 125bps of easing in 2025 if the economy evolves in line with our baseline. 🙌 Special thanks to Lydia Boussour, Marko S. Jevtic, Dan Moody, Harry S., Dipesh Khati, Eric Setiawan, Lilanthi Alahendra 📑 Join our monthly distribution list here: https://lnkd.in/dup3h4vW

Focus shifting from inflation to growth? Price action since Friday afternoon - front end yields lower and equites lower (circled) - is being pointed to as evidence, but that's too simplistic. The bigger picture is trade-offs facing central banks are becoming quite impossible now: ➡️ In this supercharged ‘world shaped by #supply’ and inflation still above target, it will be much harder for central banks to make the case that they can look through the shock, particularly after having lost control of inflation during the Covid-19 supply shock. ➡️ If oil prices do not decline soon, we believe the key question shifts from "will central banks be able to cut?" to "will their policy rates keep up with the rise in inflation?" If they don't, it means the #real interest rates - which account for inflation - will be lower, easing financial conditions instead of tightening them. ➡️ But it's not clear if central banks will hike interest rates enough to keep real rates in restrictive territory. Concerns about government #debt servicing costs could also limit how far interest rates rise.

This is a notable and unconventional policy signal. If implemented, a temporary cap on credit card APRs would function as a direct transfer from financial intermediaries to households, disproportionately benefiting lower- and lower-middle-income consumers who carry revolving balances. In a highly financialized economy, interest expense acts as a persistent drag on real disposable income. A reduction from prevailing 20–30% APRs to a 10% cap implies a roughly two-thirds decline in net interest outlays for affected borrowers. Even on a one-year basis, that represents a material improvement in household cash flow. The immediate effect would be margin compression for card issuers, partially offset by tighter underwriting, fee substitution, or credit line reductions. However, in the short run, the dominant macro effect would likely be a redistribution toward higher marginal propensity-to-consume households. From a growth perspective, this is effectively a targeted, temporary stimulus operating through the consumer credit channel rather than fiscal transfers. The broader implications depend on issuer response and credit availability, but the near-term household balance-sheet relief is economically meaningful.

Despite CRE Problems, KRE Has Ripped: The Fed, as expected left rates on hold yesterday as did the ECB, but when these Central Banks meet again in (September 18 & September 12, respectively), the high probability base case is that they will both lower rates. Powell teased a September cut that recent data (inflation, slowing job market) justifies a rate reduction. We will hear more about his stance later this month when central bankers around the globe meet in Jackson Hole. After making real progress on inflations, this will be the first time the Fed lowers its Funds rate since its lowering of the rate to 0.00% during the early days of 2020 (Covid). "The job is not done on inflation, but nonetheless, we can afford to begin to dial back the restriction in our policy rate,” Jerome Powell stated. What makes this time different from others is that the economy is strong, with the most recent Q2 GDP print of 2.8%. The Fed typically lowers rates when recessionary signs appear, which is not the case, so this time is different. Chairman Powell stated: "the economy is moving closer to the point at which it will be appropriate to reduce our policy rate; If that test is met, the reduction in our policy rate could be on the table as soon as the next meeting in September." While the Fed and ECB are expected to cut rates by 25bps in September, the BoJ raised rates for a second time ending its negative rate policy earlier this year. Yesterday, the BoJ raised its target policy rate from 0.0% to 0.25% and reduced its JGBs purchases as the Yen rallied from ¥153/US$ to ¥150/US$ in step with its equities markets as the Nikkei 225 rose +1.5%, led by banks/financials. The BoJ guided 2024 year-end policy rate forecast to 0.50%, with further expectation that March and June 2025 are on the horizon with a 1.0% policy rate target. So, while, most developed markets are on a guide path to lower rates, Japan is raising rates to normalize its rates and end a generation of financial repression which has proved so punishing for the private sector. CRE has been the windfall, but overall, the economy suffered during recent decade(s) Central Banks moving towards normalization is healthy for the economy, bringing balance to lenders and borrowers, alike. Banks should thrive in this environment, a condition we should all welcome. Federal Reserve stimulus through lower rates and a normalized yield curve should be beneficial for equities. Regional banks have performed well as of late, despite too much exposure to duration and CRE, as lower rates help with both. In addition, the yield curve will dis-invert in the coming months, and regional banks will capitalize from improving NIMs. Regional banks have been actively managing their balance sheet with savvy banks arbitraging regulatory capital requirements by executing SRT transactions that enables them to improve risk-based capital, Tier 1 capital ratios. KRE ETF: S&P Regional Banks +51% from Oct. ’23 lows

Japan is set to raise interest rates to the highest level in nearly 30 years... And the US inflation has cooled unexpectedly, giving the Federal Reserve room to consider rate cuts. Two very different signals — and that’s exactly what makes this moment important. For decades, Japan sat at the zero‑rate frontier, with policy rates near zero for almost 30 years and even negative until 2024. This anchored global carry trades, where investors borrowed cheaply in yen and invested in higher‑yielding assets overseas, and made the yen one of the cheapest funding currencies in the world. It wasn’t just a domestic policy choice. It became part of the global financial plumbing, quietly supporting risk assets, emerging markets, and cross‑border capital flows. That is now changing. Japan’s core inflation has stayed around ~3%, above the BOJ’s 2% target, and markets are pricing policy rates moving toward ~0.75%, the highest level since the 1990s. To put the scale in perspective, the Bank of Japan now owns roughly 50% of the JGB market. For years, very low Japanese bond yields pushed money out of Japan into global markets. If those yields start rising, some of that money stays closer to home. That alone can nudge global bond yields higher and make funding slightly more expensive, even without any sudden policy move. At the same time, US inflation has eased materially, reviving expectations of Fed cuts and easier financial conditions. For markets, this creates an uncomfortable divergence. This matters because it changes how liquidity behaves. Funding becomes less predictable. Currency volatility rises. Capital becomes more selective. Cheap money stops acting as a blanket tailwind and starts demanding discipline. For India, the picture remains relatively constructive. Domestic growth drivers are intact, balance sheets are healthier, and policy flexibility remains. But the regime shifts at the margin. Valuations matter more. Broad beta rallies become harder. Stock selection and quality start doing the heavy lifting. This isn’t a crisis. It’s a transition. Markets are moving away from free money toward priced capital. Returns don’t disappear in such phases, but they do get harder to earn. That’s the signal worth paying attention to.

🇺🇸🌎💵 Central banks worldwide are quietly preparing contingency plans as doubts grow over the reliability of dollar swap lines, the financial lifelines that have stabilised global markets since 2008. With Fed Chair Jay Powell set to leave in 2026 and Trump pushing the Fed to cut rates despite early inflation signals, these once-sacred agreements face unprecedented uncertainty. During the 2008 crisis, the Fed activated $583B in swap lines for non-US central banks. Another $450B flowed during Covid-19, preventing global financial contagion. These arrangements let foreign central banks access dollars when their commercial banks face funding shortages, addressing the core issue that only the Fed can print the world's reserve currency. Since then, US Vice President JD Vance has said he "hate[s] bailing Europe out," while Treasury Secretary Scott Bessent views finance, military, trade, and technology as deeply linked. As a result, future swap line access may come with political conditions. Would Denmark get dollar support without concessions on Greenland? Does the Pentagon's review of the submarine pact with Britain and Australia suggest allied agreements no longer enjoy automatic protection? European Central Bank officials remain publicly confident, yet the ECB recently asked banks to report dollar exposure vulnerabilities. Think tank CEPR has proposed a mutual pact in which 14 central banks use their combined $1.9T in dollar holdings to support each other if Fed swap lines vanish. Central banks are already taking defensive measures, increasing gold purchases and negotiating alternative arrangements with China. Bruno Colmant notes that stablecoins represent a further fundamental shift in dollar creation, bypassing traditional central bank swaps. Private American companies now issue dollar-backed tokens by buying US Treasury bills, effectively forcing foreign holders to finance US debt directly rather than through central bank channels. This ties to Izabella Kaminska's multilateral vision fund idea, which Sec. Bessent publicly supports. In his and Trump’s view, Japan, Korea, and European allies should invest their capital surplus in US manufacturing while America provides military protection and technology transfers. As Izabella notes, the setup resembles a reverse Marshall Plan, turning decades of trade surpluses into equity stakes in American industry. Weakening swap line reliability and rising stablecoin adoption could accelerate dollar system fragmentation. Treasury-backed stablecoins may prove safer than traditional bank deposits tied to central bank swaps, creating incentives for systemic change. Nixon’s 1971 exit from Bretton Woods caused monetary chaos but ultimately strengthened the dollar. Today’s shifts could prove equally disruptive, forcing central banks to choose between dollar dependence and monetary sovereignty. -- More analysis on monetary transformation in the NL Euro Stable Watch, which I co-edit with Marieke Flament 💶

Although the FOMC as a whole is still pricing in 3 rate cuts for 2024, while asset markets are discounting in 1-2 cuts, there is an increasing number of Fed officials who are either bluntly or subtly hinting that their individual base case is for 0 rate cuts in 2024. Credit markets are in better balance now, given we are no longer pricing in 6-8 rate cuts, but there is still a possibility that the outcome for interest rates is still more hawkish than currently priced in.

Fed makes big move on interest rates. A half point cut reflects growing concern about unemployment, inflation success. The US Federal Open Market Committee cut the benchmark federal funds interest rate by a half-percent at their September 17-18 meeting. The vote was nearly unanimous, with just one member preferring a quarter-point cut. The rate cut brings the target range for the federal funds rate to 4.75-5%. Base on recent experience, that should mean an effective federal funds rate of about 4.83%. The 50 basis point cut was in line with the prevailing view implied by financial markets yesterday. The FOMC members also reduced their projections of the anticipate federal funds rate path over the next few years. Their median projection for the end of 2024 is now 4.4%, down from 5.1% in June, and at the end of 2025 they expect the rate to be at 3.4%, compared with their 4.1% projection in June. By year-end 2026, the median member of the FOMC sees the rate equal to a long-run 2.9% rate. The half-point cut and the much lower anticipated target are related to a more pessimistic outlook for the labor market and recent success in reducing inflation. The median expectation of the unemployment rate for year-end 2024 now at 4.4%, up from 4% in June. The rate is only gradually expected to decline to 4.2% by the end of 2027. PCE inflation is expected to fall to 2.3% by year end, down from 2.6% in their June forecast. They now expect PCE inflation to be 2.1% by the end of next year, essentially at the long-run 2% target. Unemployment was 4.2% in August and PCE inflation was 2.5% in July. In his comments following the meeting, Fed Chair Powell emphasized the recent decline in inflation combined with growing signs of softening labor markets and overall economic activity, and concluded that the balance of risks has shifted toward unemployment concerns: "The upside risks to inflation have diminished, and the downside risks to unemployment have increased.” At the same time, he expressed the view that labor markets are still fairly healthy, “Our intention with our policy move is to keep it there." The FOMC views the rate cut as appropriate to address the weakening economy without excessive risk to the inflation goal. Chair Powell emphasized that they will make decisions meeting by meeting to reflect emerging conditions, either dialing back their rate cuts or increasing cuts if labor markets weaken more than expected. He said that the Committee is in no hurry to get to a long-run neutral rate that neither stimulates nor holds back the economy. Not surprisingly, Chair Powell took a little bit of a victory lap, saying that their ability to make this shift in focus to the labor market has been made possible by their determined fight against inflation: "Our patient approach over the past year has paid dividends." #FOMC #FederalReserve #JeromePowell #interestrates