Treasury Yields moved higher and therefore equity indices moved lower. The Fed is not done tightening, not even close. The Fed won’t tighten as much as it should, but it will tighten for much longer than many market participants expect – especially those who expect the Fed to reverse course and lower rates sometime between October 2022 and January 2023. The simple rule of thumb is that Fed Chair Jerome Powell does not want to be the second coming of Arthur Burns, the former Fed Chair who prematurely stopped fighting inflation in the 1970’s.
The 2-Year Treasury yield climbed to 3.32%, approaching its year-to-date high of 3.45% set on June 14th (see our chart below). Our view is that the Fed ought to be a fast follower of the 2-Year Treasury yield, moving its Fed Funds Rate in lockstep.
More importantly with respect to tightening monetary policy, the Fed ought to continue to shrink its Balance Sheet (and thus the money supply), by actively selling and allowing Treasuries and Government Agency securities to mature.
The Fed shed approximately $30 billion from its Balance Sheet between August 10th and August 17th. Recall that the Fed originally talked about trimming its Balance Sheet by approximately $95 billion per month and hitting this run rate by September. Doing so would push Treasury yields higher as there simply will not be sufficient market demand from sovereign nations (China and Japan in particular), nor from private funds to absorb all of the Treasuries and Government Agency securities the Fed would sell at the $95 billion per month level. Thus, Treasury yields are likely to move significantly higher in the near-term should the Fed step-up its Balance Sheet reduction activities (i.e. Quantitative Tightening or “QT”). See the Fed’s Balance Sheet below (bottom chart).
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