Transcription:
Gary Siegel: (00:03)
Hello, and welcome to another Bond Buyer podcast. I’m your host Bond Buyer Managing Editor, Gary Siegel. Today, we’re going to discuss the Federal Open Market Committee’s meeting minutes. My guest is Dec Mullarkey, managing director of investment strategy and asset allocation at SLC Management. Dec. Welcome, and thank you for joining us.

Dec Mullarkey: (00:31)
Great to be here, Gary, and catch up with your listeners.

Gary Siegel: (00:33)
So the minutes of the Federal Open Market Committee meeting came out last week and, and they gave some indication of what the Fed might do in terms of reducing their balance sheet.

Dec Mullarkey: (00:50)
Yes, indeed. That, that was kind of one of the big takeaways and what they revealed was they’re going be pretty aggressive and that they’re actually going to start potentially at the next meeting. They threw some numbers out there, and it was approximately $95 billion. So to put that in perspective, that’s like double what they did back in 2017 to 2019 and the intent to proceed at a very brisk pace monthly to get the balance sheet down. It was interesting going into this meeting that they’re actually beyond that. The other big surprise was how hawkish the tone was. And frankly, that had been set up in advance Lael Brainard, poised to become the vice chair, has been a dove for a career. And so much so that, coming in, she would, I would say she was the intellectual architect of the average inflation targeting that they came to because she was concerned for years post the financial crisis that inflation expectations would get anchored on the low side.

Dec Mullarkey: (02:01)
And that would be hard to, but, but earlier in the week, before the meeting, she was unequivocal how concerned she was about inflation and that they had to get cracking and they really had to get risk and be swift about running off the balance sheet and looking at rate increases. So that message was sent very, very early in the week ahead of these minutes, which actually led to less surprise. But when you read the minutes, you recognize that the committee has really shifted. I mean, they don’t, don’t mention anybody by name, but the entire committee has shifted to be very hawkish. And, and that was an interesting takeaway as to how they sure about fighting inflation. That is unequivocally their number one priority at this point.

Gary Siegel: (02:50)
You mentioned that in the previous reduction in balance sheet they were only doing about $50 billion a month. Now, not only are they doubling or nearly doubling that amount, but they’re going to do this while they’re also raising rates.

Dec Mullarkey: (03:07)
Right. So, that is the big, interesting takeaway here. So you absolutely ask the question as to why are they doing that? Normally the sequencing, these things, they start the rate or rate increases first and then run off the balance sheet as a second step. So the main thing that I think they’re concerned about is the slope of the yield curve. And of course when you look at the inversion that had been happening leading up to the meeting, I think they recognize that the market looks as that as a fairly significant signal that a recession could be brewing. And there are reasons why we have, or where we did have an inverted curve. And part of those are technical reasons, particularly the bond buying that’s been happening.

Dec Mullarkey: (03:57)
So I think at this point or other they recognize, okay, there’s a distortion that they’ve created here. It’s, you know, kept, if you will, the mid to long end of the curve down and they want to restore that. And that’s why I think they’re moving briskly. I think they really recognize they wan t to put more slope back into the curve. And frankly, after the meeting look at current levels, there’s like 20 basis points that has kind of been put back in that slope. So I think that’s an essential point here that they seem very sensitive about the slope of the curve because markets are, and we can argue about, the efficacy and direction that the two/10 spread markets, quite a bit of attention, how effective it’s been. But I think they recognize that and really want to move. They want to put more risk premium slash back in the curve,

Gary Siegel: (04:44)
Speaking to different analysts and economists. There are different opinions as to which part of the curve is the most important to look at. It sounds like you look at the two/10 more than anything else.

Dec Mullarkey: (04:58)
So bond managers tend to fixate on that. I would say the equity managers look at the three month to 10 year. I’m in that camp. Actually there’s another camp. The Fed themselves have from their research a preferred measure. And it sounds a little bit tedious. It’s like the difference between the three month and then the three month, 18 months, so they’re basically saying, okay, what’s that implied difference? Because it found from their own research that that is actually a better indication of recession and also, equity markets from their own research found that anything beyond that is not as effective. And interestingly enough, at this point, that difference between let’s say the Fed preferred model and the two/ten for a while. They usually travel together.

Dec Mullarkey: (05:53)
So it hasn’t been a big disconnect, but of late, those have really, really moved up. Whereas, you know, the Fed approach and Powell has chimed in on this. He said, I believe our own research. He didn’t use those kind of words, but he said, that’s the measure I would point people toward. And that actually is showing no concern that 18 months out expect a short rate to be way up there in the twos. So actually I frankly put a little more credence in that, and it’s mainly for the reason that I think there is a distortion in the two/10, right now, it hasn’t been effective. It has been an effective measure in the past for the last two recessions. It hasn’t been as great, but I do think there’s a risk premium distortion.

Dec Mullarkey: (06:35)
I think there’s a slope distortion that’s come in and we’ll see if that unfolds as, as this bond buying is stopped and run off if more of slope comes back into the curve. But, as I said, some of that is showing up already. So it does seem like we’re on the right track, at least at getting that a little bit corrected here. But as, as a recession indicator, you do need to look at a host other things. And if you were to look at other measures like the labor market look at real disposable income, retail, sales, industrial production, all of those are actually in great shape. So those aren’t signaling a concern right now. So I do think you have to look beyond, just the slope of the curve. There’s distortions there.

Gary Siegel: (07:19)
Well, they say every recession is proceeded by yield curve inversion, but every yield curve inversion doesn’t necessarily lead to a recession.

Dec Mullarkey: (07:30)
That’s absolutely true. And the gap between the curve inverting and when actually a recession shows up historically has been about 18 months. So frankly there may be a lot of measures you could find in advance that would actually give you that same projection. And again, I’m not saying people have data mind here. I think they’ve done some good work, but in many of those inversions, inversion happened, then it corrected. And, went kind of back to normal before a recession happened. So there’s there, there’s always a little bit of a story to all of that, but it does on the face seem like a very effective measure.

Gary Siegel: (08:05)
And of course, duration and amount of the inversion also matter.

Dec Mullarkey: (08:09)
Yeah, they absolutely do. And that’s the key thing. In fact, if you were to look at equity markets, they peak about on average five months before a recession, but the tricky thing there, so having said that, and you can data mine, you can see those, but the tricky thing, you know, markets, equity markets in particular go through peaks, then they’ll take a correction go back. So I think you get a lot of false signals there as well. So if you were to fix it and say look at how well the equity market has done, you would actually find a pretty good indicator from it. But as I said, a lot also false signals as well.

Gary Siegel: (08:50)
Another interesting point from the F OMC minutes, it says that many of the participants were in favor of a 50 basis point rate hike until Russia invaded Ukraine. And they also say that going forward one or more 50 basis point rate hikes is possible.

Dec Mullarkey: (09:14)
Absolutely. I mean, that’s a good call out, Gary, you look at what the futures market is pricing in, and they’re expecting 200 basis points of rate increases this year. There’re really only six active meetings left. So you’ve got May, June, July and then I think it’s September, November, December. So if you were to allow 200 basis points, you would basically say, well, they’ll probably need to go 50 basis points in May, June, July, and then change it to more of a routine 25. So there’s no question they’re going to have to do that. And I really think they’re going to front end load that because I think they want to take the pulse of the market and see how it’s coping with that.

Dec Mullarkey: (10:04)
And also, they’re saying on running off the balance sheet, they’re going to phase in that $95 billion about over three months. It’s not that big. It’s not expected to be, it’s not a phase. And, but I think they’re trying to figure out, okay, let’s, let’s get that rolling. Let’s see how the market market can cope with that. Because the one other thing is, there’s a midterm election, which is kind of buried out there, but that’s important too. And I don’t think they want to be hitting the market with these 50 basis point hits that close election. I think they want to get that out way, kind of get that noise, settled down, just see how markets are behaving. So I unequivocally think, yes, this is gonna be front end motor area.

Dec Mullarkey: (10:43)
And that’s an important point that in my estimation, they’ll probably have to do three of those. And then just round out with the other 25 and kind of get back on that pace. But that is an important point. And again, it will be interesting to see how markets take that. John Williams, who is a dove, he has signaled that already, that he sees no reason that we shouldn’t go ahead and do that. And you, you hear the dovish members in particular and Mary Daly, not a voting member, but she’s been very forthright as well. And, and she’s somebody who’s paid a lot of attention to landmark she’s coming out and saying, high inflation is as bad as losing a job.

Dec Mullarkey: (11:28)
That’s how they’re talking. So I think they want to get ahead of this, want to calm it down and, presumably, get the economy kind of down, because that’s another thing, not that I would say the Fed is politicized in any way, but going into an election, if you have high inflation it does not do a good job for incumbents. So I think they probably are a little sensitive to saying we do not want to be a factor in our timing of interfering with any of those optics. So that’s why I do think they’ll they’ll front end load here.

Gary Siegel: (12:03)
Dec you’re a 100% correct. The Fed goes out of its way, not to be seen as perhaps doing anything to influence an election. And they always are very careful around elections.

Dec Mullarkey: (12:19)
Yeah, yeah, absolutely.

Gary Siegel: (12:20)
So what do you think the chances are of a soft landing? Can the Fed make all these changes, these big rate hikes and take away all this money from their balance sheet and not cause a recession?

Dec Mullarkey: (12:36)
Well, history would tell you they do not have a good track record with soft landings. And, just as you described, there’s a lot of moving parts here. So it’s easy to say it could be a disaster here and that they’ll get that feedback and they’ll adjust. But a couple of points I would make, maybe on the other side is first of all, we’re going into this with household balance sheets and business balance sheets in terrific shape. I mean, this is probably as strong a position as you could be going into a tightening cycle. So that’s kind of number one. And the other thing which I think is relevant, is the big problem that happens whenever you have a slowdown is that companies right away react and they start to right size their organizations really quickly lay off people.

Dec Mullarkey: (13:32)
And then that feeds on itself. If people are out of jobs, consumer confidence goes way down and you really have this problem and the recession intensifies. But I’m wondering if this time around that companies will honor, if you will, that contract with their employees a lot more diligently, mainly for the reason that they have had a tough time post-COVID, getting people back on their payroll and there’s a shortage of people and you see it every day that the number of people that are changing jobs. So I’m thinking that that dynamic may play into how companies manage, if you will, a slow down and, and be less reluctant to actually do layoffs. So maybe we’ll just try to manage, maybe pass through some increases here, try to manage the bottom line, maybe accept, tighter margins with the understanding that you’re looking to go through some, some soft patch and then emerge on the other side, fully intact with all your assets, including your labor.

Dec Mullarkey: (14:36)
So that’s one thing that’s kind of different about this cycle is I guess the the strength of balance sheets going into it. And, I wonder if companies will be more careful about how active they are with layoffs.

Gary Siegel: (14:53)
We’re going to take a short break.

And we’re back with Dec Mullarkey talking about the Federal Reserve.

So right before the break, we were discussing the strength of corporate balance sheets and how the employment situation is very strong and therefore companies might not lay off people if things slow down. So do you think there’s a chance of stagflation or are we good?

Dec Mullarkey: (15:26)
So, that’s, it’s on the top of minds and it gets bantered around quite a bit. I mean, when you look at the case of stagflation that we had in the U.S., it was in the 1970s. And back then, you know, oil was a big driver and of course, commodities and particularly energy are significant drivers of the headline inflation we’re seeing today. But, you know, a couple of things have changed, certainly from the U.S. standpoint, we’re practically energy independent, and we’re less energy intensive. So, those elements are different, but stagflation is so corrosive for assets. I mean, when you’ve got a supply-driven inflation, and then you’ve got a slow down and growth, that’s just hard, hard to square. I don’t see us in that situation, I think if we hit a slow down, I think it, it could be just a technical correction, provided the action that the Fed is taking to bring inflation down makes a difference.

Dec Mullarkey: (16:27)
But it’s interesting when you look at the rest of the world, like inflation is not a factor in Asia now, Asia did not have, the massive stimulus that we had in this country’s. So a lot of what we’ve done has actually created a lot of demand here. And that’s of course, why we put a lot of pressure on global supply chains. Those things are coming under control. So I do think that the Fed can do a pretty good job managing a slow down. Don’t maybe have a technical recession, but stagflation, I think there’s a lot of other factors that are now working in our favor that would kind of prevent that. And again, the energy independence being one of them, but it’s not, I mean,if we’ve got disruption in Europe and that continues and the unfortunate war in Ukraine that drags on, and you have energy pressure there, you really could see significant spikes in energy.

Dec Mullarkey: (17:26)
Now it does seem that there’s, hyperawareness globally about how to avoid a recession. And I think even the oil producers would say, you know, we’re going to help out here and make sure that if there’s distortion or disruptions in supply that they step up. So I think central banks globally know what they actually have to do to try and avoid this. And I think the Fed has spent a lot of time on this and has commented on it. So I do think it’s, it is a risk, but I think it’s a fairly left rail risk that is out there. So right now, the probability would be pretty small.

Gary Siegel: (18:05)
So you mentioned Russia again, and their invasion of Ukraine and how that plays into everything. That was the reason that many of the Fed participants decided 25 basis points was proper now. And going forward, if they’re talking about 50 and the Russia situation doesn’t change, how does that work out? Does that make the Fed’s job harder? What happens if this Russian invasion Ukraine continues, lasting beyond the next meeting?

Dec Mullarkey: (18:40)
Yeah, so I don’t think it’s actually going to interrupt or interfere with their intent to do it. And to your point, the war is still going on, but it does seem at this point that markets have assessed the, the extent of the war in terms of, will there be a frozen conflict, will there be some reconciliation, will there be some piece of agreement? Will there be something that they can come to? I think at this point, and certainly in equity markets, you saw the shift, maybe it was like two weeks ago that all of a sudden, they just kind recognized, okay, maybe most of the risks that we’ve seen have been priced in here.

Dec Mullarkey: (19:26)
And I think that is the case. And I think that’s the view that the Fd is going to take, is that a lot of, if you will, the unknowns about the war are kind of manageable at this point. You’ve got the allies coming together, you’ve got those power structures aligned. China does not seem to want to step into this. So I think that has taken some of the risk out that some of these moving pieces are more stable and noble at this point. And that’s why I think the Fed is going to say, okay, the number one risk domestically is inflation, and we really have to move on that and kind of make some headway and start seeing, and looking at the feedback and seeing if we can get it under control. So that, that’s why I think that unless again, and God forbid, something horrendous happens there, I think most of the moving parts are noble at this point. And the Fed is looking at that same score sheet as markets are at right now.

Gary Siegel: (20:24)
So earlier Dec, you mentioned that even the dovish members of the committee are on board with larger rate hikes and moving things along quickly. There’s a possibility that at the next meeting or the meeting after that, there’ll be two new Fed members. Will that play any role?

Dec Mullarkey: (20:48)
It could, but I think there’s so much momentum right now with this convergence of all members saying inflation is the number one issue. And, Powell is in that camp and Lael Brainard who, who will be vice chair is also in that. So I do see just the momentum and the DNA of this Fed right now has turned and says, inflation fighting is our number one goal right now. I mean, they don’t mention employment now because employment market is so strong. So it is interesting that their dual mandate, which inflation and labor or employment seems fine, and that’s on track. So they’re basically saying, we just got to take care of this long overdue issue that some people would argue, but I think that’s how they’re thinking at this point. And I think members joining that lineup probably understand and see that, and probably would have little influence if they wanted to go the other way.

Gary Siegel: (21:46)
That’s very true that now inflation is their number one goal, but even a year ago, or less than a year ago, they were saying that inflation was transitory and they were more worried about employment.

Dec Mullarkey: (21:59)
You’re absolutely right. I mean it is interesting. That’s the one thing, and you kind of hit on it, maybe my sentiments over the last several, six months. And I certainly give the Fed a lot of credit, I think, okay, maybe they waited too long, but when they moved and they kind of moved in two quick passes, one was kind of toward the end of the year to recognize, okay, it’s not transitory. And now recently they’re kind of just jumping out there and saying, wait a second, it’s really not transitory. And we’ve gotta bring all the fire power with doubling up on the rate increases with really accelerating the balance sheet reduction. So that all happened, I think, fairly quickly in terms of Fed speak. And, I understood why they actually waited so long, because in prior recoveries, they probably moved too quickly.

Dec Mullarkey: (22:46)
It felt, certainly after the great financial crisis, they moved too quickly probably, and hampered the recovery in some way and disadvantaged people at the lower end of the labor market. And I think they wanted to see a full recovery, but they got their wish. And now I think they’re taking the steps where they basically say, we have to now adjust the dials here. We’re a little bit overheated and let’s get that under control and sustain if you will, a more average level of growth going forward here.

Gary Siegel: (23:15)
It’s also interesting how open the Fed has been. Before the last meeting, Federal Reserve Board Chair Jerome Powell came out and said that in his mind, it’s a 25 basis point rate hike. You never would’ve heard that from Alan Greenspan or any of the other previous Fed chairs.

Dec Mullarkey: (23:37)
Yeah. You you’re absolutely right. I mean, it’s interesting with Powell, and this has been his approach. I think a lot of Fed officials learned their lesson or, the current regime saw what happened with the taper tantrum is that, if you don’t manage markets well, and that’s not to cater to them, but he is actually got a very matter of fact style, but I think the markets have embraced. And he was criticized quite a bit, and I think maybe unfairly when he first started, they said, oh, his communication, isn’t good. But I think actually he’s done a very, very good job. And he has found his,to your point, he has been upfront saying like, this is what we’re seeing. This is what we’re doing.

Dec Mullarkey: (24:22)
And you know, when the war hit you’re right, it was 50 basis points certainly was off the table and all that, but then they adjust. They say, okay, those things are contained. Now inflation is the real risk. And they’ve kind of got back on site and with the communication that they have done markets have not rioted, they’ve priced it in. In the grand scheme of things, they’ve actually, markets have acted very, very rationally in all of this and particularly equity markets. And even with the inversion, I think markets accept it. Yeah, there’s maybe a little distortion here on risk premium and that’s going to get corrected here and the slope is going to return. I do think the only skepticism the market has is, can the Fed really continue at the pace that they have on the table.

Dec Mullarkey: (25:10)
And the Fed, you know, fed funds has priced it in, but I think, I think half the market thinks they won’t be able to follow through here. They’ll have to pause at some point that we’ll start to get some tough prints on activity interruption or whatever, and they’ll have to dial it back now, the truth, and this is of course, maybe getting back to the earlier question about, how easy is it to deliver a soft landing. There’s always delayed effects. So when they see soft data, there’s usually a lot baked in. That’s going to just roll through regardless of what you do at that point. So that will be kind of a challenge here as we go. But, I overall give the Fed a pretty decent grade on where they have to your point been very transparent, been very clear in their communication and you’re right.

Dec Mullarkey: (26:01)
The opaque approach of Alan Greenspan left everyone leaving the room going, you must be a genius because nobody understands him. But he could get away with it. I don’t think, I think markets are more demanding and maybe fussy. And of course the truth is the Fed is a huge agent in the market. It’s as big as it’s ever been with a $9 billion balance sheet. It really, it makes a difference not only to the U.S., but globally. So I think they recognize that we they’ve gotta be a lot more careful and subtle with adjusting the dials here and trying to get their story out there and explain their position. So they, no one has these major interruptions here or liquidity crisis or whatever. So I think that’s part of it.

Gary Siegel: (26:49)
And despite this transparency at the press conference, after the meeting, Powell, didn’t say anything about the discussion on how much they were going to reduce the balance sheet, but in the minutes it was pretty clear what their expectations are.

Dec Mullarkey: (27:05)
Yeah, yeah. That was, it’s a very good point. Because, I had the same reaction. I said, oh, everyone just accepted that’s what’s going to happen. I mean, there was a little back and forth, in comments. Well, I think there’s more from pundits about, well, can they really, will they need to sell some MBS to get up to $35 billion because the treasury runoff, that’s usually pretty obvious. You’ve got expiration dates that are hard on those where mortgage-backed securities are callable. You know, they have long dates, but people can prepay and all that. So then the question was will, will they sell some of that to get to their $35 billion? And I think they will. I think they’ll actually stay committed to that because that’s the other thing they’re looking at is obviously the mortgage-backed securities have some influence as all of their policies do on mortgage rates.

Dec Mullarkey: (27:54)
And I think they don’t wanna cause too much distortion. They really wanna not favor one asset over the other. They’ve been, they’ve been pretty clear in most of their communication. And, when they did tapering in the past or runoff, they kept the proportions between treasuries and MBS in a tight bound. Because I think they think there’s a message being sent if they actually choose one over the other. So, but to your point, it was surprising. I think markets just said, okay. And they, as we mentioned earlier, it was double in the normal size that we’d seen in the past and markets didn’t flinch. I said, OK, this is where we’re heading.

Gary Siegel: (28:34)
So what’s on your clients minds now, given all that’s going on with the ‘Fed.

Dec Mullarkey: (28:40)
Yeah. So there’s a number of things. I think people are focusing on there and, and maybe to go through them in just short order is you’ve got interest rates going up, which is affecting mortgage rates. And the concern now is okay, well that’ll slow the housing market and the housing market was pretty hot. So anybody that’s in their home, clearly not in an issue unless their mortgage is resetting, but it probably will slow new sales and you see that already. You see, I mean, if you, if you look at home builders, you know, they’re down 25% this year because the expectation is okay the housing market is going to slow. So there’s one area of how much does that slow?

Dec Mullarkey: (29:27)
There’s another factor that actually comes out of that if fewer people that can afford homes just where interest rates are right now, they’ll probably have to remain renters. And that’s actually gonna put a little more pressure on rents, which have been going up. So the housing market is one that jumps out there. The other, a couple of the other ones are you look at real rates, real rates have come up quite a bit on the 10 year, you look at the beginning of March, they were a hundred basis points negative. Now they’re up to about close to zero they’re up, maybe 18 basis points negative. So as those go up, they do put more and more pressure, as the real rate goes up, it puts more and more pressure on equity markets and asset prices in general.

Dec Mullarkey: (30:11)
Now there’s there’s room for it still to run. But if that ramps up very, very quickly, I think you could see some asset corrections there, asset price corrections. And then there’s the strength of the dollar. The dollar has been strenghening. I mean, with the Fed kind of moving at the pace it is relative to other central banks, it has strengthened the dollar and that can put pressure on exports. And also obviously for the S&P something like 40% of the revenue comes from overseas. So you could see a little bit of a hit there to profits. And then I think ultimately, it comes down to, will lending conditions tighten, will banks tighten here and, that could, again, cut some access to credit for particularly for small companies and overall financial conditions would tighten if the Fed does pay quite a bit of attention to general financial conditions.

Dec Mullarkey: (31:08)
So I think they’ll be pretty sensitive that, but all of these parts with, you know, more expensive funding, potential pressure on corporate margins, those are starting to become more and more intense as we kind of move through this. And it, it depends how companies navigate. Companies will be able to pass through some of the inflation. They have been doing that. They’ve been passing through some of the costs, but there’s a point at which, some of that might hit margins. And again, asset prices may take some of the correction as some sort of correction as we’re going here. So I think, all in all investors always worry about that mix and you know, that whole handoff and how, and what it does, any type of moderation and growth the concern is, okay, will it spill over in some type of shock into some sectors and that’s where everybody will continue to do their whole homework and making sure they’re fairly balanced, I think, in their allocations and diversified so that they can, at least not be overly concentrated in something that might take a big hit here as we go forward.

Gary Siegel: (32:15)
Well, Dec, I want to thank you for your time and for your opinions. I’m sure this was very helpful to our listeners.

Dec Mullarkey: (32:22)
Gary, great being here and great catch up. And, I echo your, your sentiment there. Hopefully it is helpful, but thanks for the opportunity to chat with everyone.

Gary Siegel: (32:31)
Thank you for listening to The Bond Buyer podcast. I produced this episode with audio production by Kellie Malone special thanks to Dec Mullarkey, managing director of investment strategy and asset allocation at SLC Management. Rate us, review us and subscribe www.bondbuyer.com/subscribe. From The Bond Buyer, I’m Gary Siegel. And thanks again for listening.