Transcription
It's a violent day for markets as the Fed kept interest rates unchanged.
Today, as you know, our committee decided to vote by 9 to 3 vote to maintain the target range for the federal funds rate at 3 and 1/2 to 3 and 3/4%. The economy is showing impressive resilience. Even with recent shocks, the trends are positive and reveal solid growth. Job gains have kept pace with the workforce and the unemployment rate has changed little.
Kevin Warsh at the FOMC made a series of announcements that caused the Dow to crash 1,000 points and caused the long end of the curve, the 10-year and the 30-year, to spike while the short end of the curve, the 2-year, fell. Why did this happen? Why did the yield curve steepen and why did equities markets react so violently? What exactly was announced and what can we anticipate from the Federal Reserve and markets alike going forward? We'll get all these answers and more with Kumal Sri Kumar, president of Sri Kumar Global Strategies.
This video is brought to you by and sponsored by Kalshi, the largest prediction market in the United States. Unlike a sports book, you're trading peer-to-peer on real-world events from economic data to political outcomes and the price moves based on public opinion, not a house. Go to the link in the description down below or scan the QR code here and new users who use my code LIN l i n can get up to $500 if you trade $25. Kalshi is CFTC approved and available in all 50 states including California and Texas.
All eyes are on the Fed and so the trade called Fed Decision in September is going to be something we'll be discussing with Sri today. We're going to go over what we can expect from the Federal Reserve by the next meeting and beyond. And right now traders on Kalshi are placing a 54% chance that the Fed will hike by September. Does our next guest agree with this? We'll find out. If you agree with this, you can put $50 down and your payout could be $88 if the Fed does raise by 25 basis points in September.
Sri, welcome back to the show. Good to see you again.
Good to be with you, David. Especially on an important day like this.
Absolutely. Before I recap for you some of the highlights from the FOMC press conference, my first question, why such a violent market reaction from not just equities, but also the bond markets? What did the Fed say?
The reaction, David, if if it had all stopped at 2:00 p.m. Eastern time, meaning that we just got the FOMC decision and nothing further happened, I don't think you will be seeing the carnage that you saw since. A good part of it happened in the last hour to hour and a half of the market remaining open. What happened then was the beginning of the wash press conference at 2:30 p.m. Eastern time and ending about 45 minutes later. And what he showed was that while three regional bank presidents dissented from the decision, wanted to hike interest rates, he stood on the side of saying, "Let the market do what it wants to do. I'm not going to do anything." What we saw was a Federal Reserve where the members collect their salaries, including the chairman, but they don't want to act. They tell you that they want to bring inflation down to 2%, but they don't do anything about it, and that's what I think the market was reacting to.
It's strange how a lack of a hike today pushed yields up. We'll get back to that in just a minute. Let me play for you one of the questions, which is why they didn't raise today. Take a listen.
Um so, the Fed funds rate is now about 75 basis points below the two-year yield. Suggest markets think you'll have to tighten eventually. About 100 basis points below most Taylor rule estimates. You're hitting your employment mandate, inflation stays high. Why should rates not be higher today?
Rates are higher today than they were 42 days ago. Um markets have made decisions because we step back in part from trying to influence those. Market judgments have moved up on what nominal rates are across the Treasury curve. That doesn't mean we take them as by dictation, but we're observing them. So, I think it's a mischaracterization to say that markets haven't reacted because we didn't move today. Markets are reacting in real time. Uh monetary policy matters not just by what we say or even what we do. Monetary policy matters by how it affects the real economy. And these prices that we see in financial markets is one of the many ways in which it affects the real economy.
He didn't directly answer the question. He the reporter asked him rates. And I think the I think it's clear the reporter was referring to Fed funds rates. And then Warsh said, yes, the Fed funds rate didn't move, but the 10-year yield and the 30-year, they already moved. Is he basically admitting that the Fed doesn't need to hike rates anymore and the market can the bond vigilantes will do that work for them?
I think Warsh was saying, David, is that the markets moved in a direction that they should move even without the Federal Open Market Committee operating, working. So, he says, what is the problem if you even if the federal funds rate is not increased, the bond yields have reacted. He specifically mentioned that the 10-year and 30-year yields have moved up a lot in recent months. But here is my question back to him, David. The Fed ought to be leading the bond market, not following it. What he said was I did not react, but the markets are reacting, which is the reason why we saw the yield curve, the steepness of the 2 to 10 year yield curve was enormously steepened. It went up about 11 basis points, which is a 35% increase widening in one single day, most of which happened in 2 hours. And so, what it means is the markets are saying we are going to act. It doesn't simply doesn't matter what the Fed does. And that's not a happy situation to be in.
If you were at the Federal Reserve today, would you look at the Iranian situation with the situation in Iran as reliable data? What I mean by this is just a couple days ago, there were talks that the Iranians and the US could enter a new round of peace talks. There was a temporary pause in attacks. Just and oil went down from 90-something dollars back all the way down to 80-something dollars in the WTI. Just today, we had a surprise Iranian missile attack on US forces. Oil prices surged once more, which partly contributed to the um stock market going down at opening bell even before the FOMC conference. With this kind of volatility, Sree, is oil still a reliable indicator of future inflation expectations, do you think?
Oil is still a valid indicator. Yes, the oil price fluctuates, but then I think what you need to take into account is how real is the is the ceasefire in Iran. And in my writings, week after week, I've been saying that the ceasefire is all temporary. Longer term, the war is going to continue. Remember, this war was supposed to end in 2 weeks when it began on February 28th and it is still on. So, I would say that the direction of oil price is higher, even though there are fluctuations in the short term. So, the impact on inflation is going to be upward because there is no short-term correction coming down of the oil price anytime soon.
Right now, uh there were Well, first I'll show you a prediction odds in just a minute, but going back to the three dissents, um does that indicate to you a strong likelihood that Warsh is going to be pressured to eventually hike rates not you know, he didn't do it this time, but at the next meeting.
The pressure is going to come on Warsh to hike, but not by the number of dissents because keep in mind that if you would even in the with nine people voting, he can have four dissents and yet have a majority which is saying the same thing and the majority decision holds. Where the pressure is going to come on him is going to come from the markets. If you have a few more days like today with the third 10-year and 30-year yield surging and the cost of a mortgage is rising or for you to get a loan to buy a car >> Mhm. >> goes up substantially then there is going to be political pressure on him to act. That's where I think the pressure is going to come from rather than from the number of dissents in the FOMC.
Remember before the FOMC had met, the Nasdaq was already down on the day. >> Uh-huh. >> And it just went down even further after the FOMC. What would have had to happen for the markets to end up positive in the day? In other words, what would Warsh have needed to say to turn markets positive?
Here is what he should have said and here is what I would have said if I were giving the talk. I would have led a quarter point increase in yield and then you might say, "Hey, isn't that going to be negative for Nasdaq and the equity indexes?" You make a core quarter point move and say, "This is not the start of a trend. We have just done it with a supreme allowance element of caution. We are going to watch for several more months before we act." In other words, that is called forward guidance. But you have a chairman who doesn't believe in it, who doesn't believe in telling the markets how he's thinking and where he's inclined. And that's why the equity indexes, particularly Nasdaq, went down even further after he spoke.
What can you as an economist use as forward guidance from the Federal Reserve? So this is from Kalshi prediction market. Which Federal Reserve presidents will be broken? Dot plot omitted 32% trimmed mean emphasized 27% Reserve president rejected 15%. Warsh has mentioned in his first FOMC conference at the last meeting a couple months ago that he would remove forward guidance statements from the from the release and not use that kind of language. And now people are predicting whether or not the dot plots will be abandoned altogether. If that's the case, Re, what would an economist need to see or look at for forward guidance?
The the markets would really and the economists as well would need a clear statement from the chairman on where it is headed. It is okay if he has to change the outlook based on circumstances. If he said, for instance, that interest rates are going to be coming down and then there is a the Iran war begins and then he has to say, "Nope, we are not going to cut rates anymore. We have to watch it." Which is perfectly fine. But right now we are operating in vacuum. And in terms of the precedents being broken, the principal precedent that was broken in the Federal Reserve is giving some element of guidance for what the market says. Now, the problem Here is the problem, David. He thinks he's walking in the footsteps of Alan Greenspan, a legendary former chairman of the Federal Reserve, who passed away recently at the age of 100. He thinks like Alan Greenspan, he also can go ahead without providing uh forward guidance and can not provide any information. But, Alan Greenspan came upon it after a number of years of service in the Federal Reserve, and people came to know him and have confidence in him. Here is this young chairman who's trying to do that in his first meeting, and it's not going to work. And that has been my position all uh all around, and I continue to believe that that is his principal weakness today.
I want to show you one more clip. This is a question on supply chain disruptions and inflation. Take a listen.
How are you factoring the fact that a large portion of the inflation overshoot is being caused by supply shocks, as it's mentioned again in in the statement? Does that blunt the effectiveness of rate hikes in your view?
Um first, on the premise of your question, it was almost as if you were listening to our discussion the last day and a half. A lot of our focus was on trying to understand and identify underlying inflation dynamics amid shocks. We take these shocks seriously. There have been a series of them that have been hitting this economy. We're not looking through them and saying, "Oh, they don't matter." What we're trying to understand is to what extent are these shocks broadening in their effects, broadening in their impact on prices that are quite far removed from it. Our goal is to have growth that is broadening, and inflation that is becoming more limited, more circumscribed. Uh I'll be the first to admit the shocks make this job and this policy conjuncture a little tougher. But that's among the chief questions we've asked ourselves, and around the room people have different views on it. I tend to think going the coming months we're going to refine that view and have a better judgment. And we're going to have market prices trying to help inform it, too.
What is your interpretation of what we just heard, Sree?
I I think my interpretation of that is he's just kicking the can down the road. He does not want to take any action in terms of higher interest rates. He's certainly going to get into trouble with President Trump if he does that, because the president said just 2 days ago he does not want a rate increase to take place. So he's trying to avoid it. It reminds me, David, so much of 2020 when there was a big increase in the Fed balance sheet and the Jerome Powell there was a cut in the policy interest rates to near zero because the chairman kept saying inflation is transitory. Here you have a chairman who says he's studying the situation hard, there is nothing he has to do, and he will take action when it is appropriate in the future. My concern with it is it's already too late. By just setting up task forces and waiting for another 6 to 9 months to make a decision he's going to make the inflation situation significantly worse by the beginning of 2027.
When you say he's going to get in trouble with President Trump because Trump wants lower interest rates, what what does that mean? The Fed doesn't operate underneath the administration of the president. They're supposed to be independent, right? So practically speaking, what could happen to watch?
Nominally, the Federal Reserve supervisor is the US Congress. The the Senate and the House supervise it supposedly, not the president. However, all presidents have been aware that what the Fed does has an important impact on their prospects, on the prospects of their party in a forthcoming election. So, that's where you get a divide, a conflict emerging from that situation. Now, how can the president affect it? As we saw in the case of Jerome Powell's chairmanship, he called him all kinds of insulting nicknames. He called him a He called him a stupid, and he said he was going to fire him. And the case is if Walsh persists on increasing interest rates, the same thing is going to happen to him. So, unless you're willing to tolerate those insults, you probably say, "Let me be more careful. Let me postpone the rate hike, so that at least uh for another 3 months, the the president will not be calling nicknames while I'm setting up epithets for me." And that's what I think happens. The president can affect by uh jawboning, by asking you not to increase interest rates, but he cannot directly force you to keep the interest rates low.
Okay. So, ultimately, then, when can we expect a rate hike? Actually, you know what? Before we go go there, this is from Kaushik. Fed decision in September, traders are placing 54% chance of a hike by September. Forget Forget for Kevin Walsh's stance. What do you think should be the correct policy by the next meeting in September, just from a purely economist's standpoint?
The correct policy should have been, even in the June meeting, which was the first meeting for Kevin Walsh, there should have been an increase. Now, we are in July. At least he should have increased it today. Neither of that happened. So, I think we have September, I'm going to say they should hike up by 50 basis points because they've been so inactive for such a long time. But, is that going to happen? No, it will not. At most, you're going to have a 25 basis point increase taking place. When will we get the first indication of that? In the final days of August, we have the annual meeting in Jackson Hole, Wyoming, which is very closely watched because the Federal Reserve usually gives signals as to what it's going to do, and we may find out by late August more as to whether there is going to be a rate hike in the month of September.
I uh I recall that the ECB already started raising rates, and I also recall that in 2008, the ECB raised rates because the oil price was spiking all throughout 2007 and 2008. In hindsight, they were reacting to energy prices going up, which feeds into inflation data, and that was a policy mistake because they hiked right into the banking the global financial crisis. Now, I'm not saying this is a policy mistake that the ECB already hiked rates. I'm I'm I'm I'm just wondering, Sri, how do we know if inflation is persistent, which will necessitate, like you said, a 25 or even 50 basis point hike, or if this was a one-off, and hiking turns out to be a mistake because there was a greater financial crisis that could come from it?
Those are excellent questions, David. Let me parse it and divide it into parts, if I may, and answer you. July 2007, you're referring to the rate hike by Jean-Claude Trichet, the head of the European Central Bank at that time. When he did that, I wrote in my report that the ECB made a serious mistake. He did that because in May of 2008 to May of 2007 and then going into May of 2008, oil prices were rising. Oil prices hit a high of 148 US dollars per barrel. And he decided that that meant global inflation was a big problem. My answer response to that ECB move in 2007 was it happened because the US dollar was very weak. And since the dollar is priced in dollar terms, you also had the price of oil went up to keep the purchasing power of the of the oil producers. Today it is different. It is different because there is clearly an inflation signs of inflation which have gone on for a long period of time, number one. Second, Europe is much more dependent on imported energy than is the United States. Europe has been hit lot more by the war in Ukraine than the United States. So for all of that reason, they made a symbolic one rate hike. And they didn't they've not increased it since. More recently, they stayed away stayed away from it. So what you can do with the transitory versus permanent problem which was the last part of your question, is you make an increase, explain clearly what you are doing, and then say if I am wrong, if there is no persistence of inflation, we will either keep the interest rate constant or even bring it down. That is what they have to do so that they are very cautious on both sides and I think that is the caution that is missing in the case of the Federal Reserve.
You told me in April that the Fed is probably going to cause a steepening of the yield curve. This is more More what we saw today. So, I think what you're predicting is starting to play out. The two-year fell slightly while the 10-year rose dramatically. Why did that happen?
Uh it happened because it is a reflection of the market's loss of confidence. Uh I of the Fed, the loss of credibility with the Fed. That is what is reflected by the steepening yield curve. The two-year yield, David, is a faithful reflection of what the market thinks is going to happen in the short term. So, they are saying at this rate there may not be a rate hike even at the September meeting, which is why the two-year yield went down. However, the 10-year and 30-year yields are set by the market. So, they think if the Fed is not going to act, then inflationary pressures are going to increase further, and therefore the bond yields have to rise to compensate for the higher inflation. And what does that mean? The yield curve steepens because the two-year went down and the 10-year went up.
So, just to clarify, the steepening of the yield curve could signal a few things: higher inflation expectations, economic growth, uh or perhaps boosted bank or boosted um like you said, loss of confidence in the Federal Reserve. Now, we talked about that. We've talked about inflation expectations. Could this signal also underlying economic growth, Sri?
Uh the signal can show that the economic growth is vibrant because the US economic growth is clearly uh stronger than what you have on the other side of the Atlantic. So, that could be a reflection also of the bond yield, but the question you have to ask, David, is why today? Why did the yield surge just today? And that's not because suddenly the market got optimistic on the US economic growth. Today's development is more Fed-related rather than economic growth-related.
Does a steepening yield curve mean better better performance from the financial sector, banks for example? Typically, banks borrow money on the short end of the curve and lend money on the long end. So, in theory, their net interest margin should improve. What do you think?
Uh the in the short term, you're absolutely correct. The bank earnings are going to benefit from the yield curve steepening. And one little thing that matters thereafter is is it just a case of yield curve steepening? Because if the yield curve steepening pushes the economy into a recession because it becomes more expensive to buy a house, it becomes more expensive to get a car loan, and if that causes a recession, then the bank earnings will go down with it. But the short-term impact is clearly going to be positive.
Looking ahead, Sree, what are the investment implications of a more opaque Federal Reserve, so to speak? Uh steepening yield curve and perhaps loss of confidence in the Federal Reserve to do the right thing and having the bond market step in.
Uh first impact, short-term versus long-term investment. If you are a good trader, you are going to benefit a lot more than if you are a long-term investor because this kind of Fed behavior is not good for long-term investments because you don't It is very opaque. You don't know what the Fed is going to do. That's the first thing. Then on the bond versus equity side, there are no winners. Or as we say in the in the parlance, the 60/40 portfolio is going not going to protect you because both equities and bonds get hit. So, the last part of the prescription is be relatively short-term in terms of your duration on the fixed income. Be more value-oriented, more careful in terms of what the valuations are. Uh rather and protect the principal rather than try to shoot the lights out with phenomenal returns at this time.
I like to play for you one last clip from the FOMC press conference that I like. This one has to do with the mandate on preserving price stability. It's a rather challenging question from the reporter. Take a listen.
You've said over and over again that your job is to bring down prices, to get prices stable, to hit your target, and that you will hit your target. The market says you're not there yet because they've raised rates. Uh but all you've talked about today is talking about it. And it's not like members of the committee weren't there before you talking about it. So, I guess what the American people might be asking is what are you waiting for?
So, the decision we made today, the discussion we had in that room, was the farthest thing from inertia I can imagine. As a point estimate at this very moment in a choice between two alternatives, you heard the results of it. But, I would tell you that this discussion was far more robust and our thinking about how best to achieve that target is advanced. And over the coming months, I expect it to be advanced much more significantly.
If you were to sort of If I were to steal a follow-up question, I won't let you You won't be giving it up. If I were to steal a follow-up question, well, what's what's what's the world think about what you've done? If I look at the Treasury curve, if I look at the dollar, if I look at a lot of things that are internals inside of financial markets, I think what they're broadly saying is um that this committee does own it, has the credibility to deliver it, and they believe like I do that we will.
Okay, let's stop it here. That's a good question. What is he waiting for? I think he gave his own answer, but what is your answer? What will finally trigger of Kevin Warsh to say, "You know what? I don't care about Trump. We need to raise rates."?
He's what He is going to do it when he's absolutely forced into it. In other words, the 10-year yield just goes beyond control and there is havoc in the markets. And then uh the markets decide that the Fed is so far behind the curve that he has to increase interest rates. That's what he's he's saying. And let's go to the other part. Uh uh Michael McKee at Bloomberg, who asked the question, is a again an experienced journalist. And he said, "What are you waiting for?" And I'm asking the same question. He's now waiting for the task forces to get back to him. My response is, "Are you kidding? Inflation has been above target for 63 months in a row, and you need another task force to come and tell you that inflation is high? You can't see it yourself? So, what I think he's doing, David, is to say, "Hey, don't ask me to make any decision right away. Maybe having a task force will let me um postpone it for another 6 months." That is what I think he's waiting for, which would be the honest answer if he had wanted to give, is to say, "I'm kicking the can down the road. I really don't want to make a decision today, and I'm trying to decide how long I can postpone my decision-making cap- capability."
Sri, why haven't we talked about yield curve control? You mentioned that a long a much higher 10-year yield or even 30-year yield would force Kevin Warsh to raise rates. I posit that the Federal Reserve under Kevin Warsh has the option to buy Treasuries on the long end of the curve and push down the rates artificially. Why haven't they considered that?
Very good question. I'm sure they are thinking about it. And here is a piece of historical statistic which would be relevant here, David. The last time the yield curve control was practiced in the United States was in 1951.
Wow.
The question is why why was why no yield curve control since? They did that in the aftermath of the federal deficit getting out of control during the Second World War spending. Then we had the Korean War in the late 1940s which kept the defense spending very high.
Mhm.
And the US Treasury asked the Federal Reserve to support the bond yield by buying bonds and maintaining the yield at a certain level. What the Fed found out was the in exchange they were giving up their independence. They became totally subservient to the Treasury simply providing all the cash that the Treasury wanted for its purposes. Why is the Fed not done it since? Because that yield curve control experiment was a disaster. The Fed decided that they no longer wanted to support it in early 1951. They withdrew from the bond market and bond yields surged. And bond holders had a huge loss. So if the Fed were to do yield curve control today for the next year, year and a half, they can keep the yield down. But as the fiscal deficit keep keeps increasing and the bond market sees it they are going to test the resolve for the Fed to maintain the interest rate. And then they would find the Fed no longer can hold it. The Fed gives up, and you one fine day you have a 50 or 70 basis points increase in yield on a single day. That's what happens, and a huge loss and blood on the street as a result of that move. So, I don't yield curve I've written about it and said yield curve controlled, you can try it for a short time, but the price you'll have to pay is that the eventual collapse of it is going to is not worth the price.
I believe Japan has been using yield curve yield curve control for years, even despite the Americans not using it since the '50s, like you said. What can we learn from the Japanese experience?
What we can learn from the Japanese experience is not to do it. Look what happened in the Japanese case. They were trying to keep the 10-year JGB yield at close to zero, and it we have surged a lot higher since then. The yen is weaker, and it is very difficult for the Bank of Japan to control the yen and control the yield. And I don't think that was that's a path you want to follow uh if you want stable economic policy following from it.
Do you think central bank policy right now is going to actually cause more inflation even forget forgetting the oil spike from the Iran crisis?
Uh I think I do. Even before the Iran war began, uh you see in my writings, I said the Fed should have increased interest rates even before February 28th as a precautionary move in order to prevent inflation from rising. The Fed did not do that. Then came the Iran war, and then the uh inflationary impact has increased. The Fed still has not increased interest rates. So, I think the So, the longer they delay, the greater will be the price that will have to be paid. There is no escaping from it.
Are any assets in danger from upcoming Federal Reserve monetary policy? We already saw equities fall today from this lack of confidence that we talked about. But is there anything else that we can expect uh in terms of risks?
I would say that the ones which are uh subject to risk, I would mention two of them. Not they're not exclusively the case, but they are the top of my list. One is the Nasdaq, which is very dependent on interest rates. And if they find that the interest rates are going to increase significantly, Nasdaq-oriented stocks get hit. Second would be long-dated bonds. We again got a one preliminary cautionary warning today. And it it might get a lot worse uh in the months to come.
Would quantitative tightening um intensify quantitative tightening, which is a shrinking of the Fed balance sheet, be used instead of rate hikes? Let's say, you know, Powell wants a middle ground. He doesn't want to upset Trump, but he doesn't want to upset the bond markets, either. Well, he doesn't have to move rates. He could just reduce the bank balance sheet. How would he do that? If that Is that an option?
I would say he spoke about it when he was a candidate for chairmanship because he gave it as the all of us as a reason why he can cut interest rates because he can offset it with a reduction in the balance sheet. But today, I don't think it'll work. Because if he reduces the balance sheet, with inflation remaining so high, you're going to have a what we call a financial accident like uh like the Silicon Valley Bank in 2023. Uh we had a cash crunch in September 2019. You may have a repeat of that. And then then the Fed typically stops quantitative tightening and switches over to quantitative easing, provides liquidity, and completely changes policy because of the danger it caused. So, I don't think that's going to work. It maybe it got uh Kevin Walsh his job, but I don't think it is going to help him perform his function as chairman of the Federal Reserve.
I appreciate your thoughts. That was a lot to go over in a very volatile day. Thank you, Sri. Bottom line, last question, can we expect more volatility up ahead, or do you think that eventually when we get a hike sometime this year, maybe September, maybe the next conference after that, eventually markets will stabilize and get used to it?
My view has been and it continues to be that unless Kevin Walsh changes his policy and provides us some guidance on how he's headed, there is going to be more volatility. We saw that today. And I if he is not going to change the way he acts, we are going to have lot more volatility during the months to come. The only way in which I would tell you, David, that there's going to be less volatility is if he completely transforms, if the situation changes, he provides more forward guidance, he increases the interest rate uh in a in a precautionary manner. Any of those would reduce the volatility, but right now uh there is no way he's going to be able to achieve it.
Excellent. Thank you very much. Sri, I appreciate your thoughts. Where can we follow you and read your work?
You're very welcome. Uh on Substack on I'm on sreeconomics.substack.com. I'm also again on the internet on sreekumarglobal.com and on X. Uh my handle is @sreek global. And any one of those and I my weekly writings on Saturday on the Fed and the interest rates uh I put out Uh people can either subscribe, there's no paywall, or I put it on X as well every Saturday.
Excellent. Appreciate it, Sree.
Thank you very much. It's a pleasure to be with you, David.
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