Joseph Wang & George Goncalves on Rates, Tariffs, Fed’s Balance Sheet, and Yen Carry Trade
Monetary Matters with Jack Farley
Deep Dive
What is the Federal Reserve's game plan for 2025, considering the recent election and potential policy changes?
The Fed is likely to adopt a wait-and-see approach due to the uncertainty surrounding President Trump's second term policies. They are cautious about the potential economic impact of tariffs and migration changes, and are likely to be reactive to new developments. While there are stimulative factors like tax cuts, the Fed may need to cut rates to support the economy and avoid a recession.
Why is the December 2024 interest rate decision a close call for the Fed?
The market is currently pricing a 50-50 chance of a rate cut in December 2024. The Fed is likely to cut if key data like PCE and NFP do not show strong economic activity. However, if the data is very strong, the Fed might choose to pause and avoid looking political.
How might tariffs affect the U.S. economy and the Federal Reserve's policy decisions?
Tariffs can create economic uncertainty and dampen business confidence, which could lead to reduced investment and hiring. While tariffs may not be inflationary in the long term, they could prompt the Fed to cut rates to support economic activity and mitigate the impact on small and medium-sized businesses, which are more vulnerable to higher interest rates.
What is the current outlook for the 10-year Treasury note?
Both Joseph Wang and George Goncalves believe the 10-year yield is likely to head lower in 2025 due to potential economic volatility and uncertainty from trade policy. The market seems to be pricing in a range of 4.25% to 4.75%, but there could be more downward pressure if the Fed cuts rates more aggressively.
Why do George and Joseph think the 2-year Treasury yield is likely to decline?
They believe the Fed will cut rates more than the market expects, which will push the 2-year yield down. The current high rates are restrictive and could lead to economic deceleration, especially if fiscal policies and tariffs disrupt business activity. A steeper yield curve, with the 2-year yield declining more than the 10-year, is a likely scenario.
What are the potential economic impacts of a significant reduction in the U.S. fiscal deficit?
A reduction in the fiscal deficit, from 7% to 3% of GDP, would likely be contractionary in the short term. It could lead to economic volatility and negative impacts on financial markets. However, in the medium term, it could be positive if it leads to more efficient government spending and redirects resources to more productive sectors.
How might the Federal Reserve's balance sheet evolve in the coming months?
The Fed is likely to end its QT (Quantitative Tightening) program in 2025 to avoid plumbing issues and ensure the banking system has sufficient reserves. They may reinvest proceeds from maturing mortgage-backed securities into treasuries, potentially leading to an increase in their treasury holdings. The demand for liquidity by the banking sector will play a crucial role in this decision.
What is the concern with the yen carry trade and its potential impact on global markets?
Wide interest rate differentials between the U.S. and Japan can lead to carry trade adjustments, which have historically triggered crises in emerging markets. A strong U.S. dollar and high hedging costs make it less attractive for Japanese investors to buy U.S. treasuries. If the Fed takes longer to cut rates, it could expose global borrowers to higher costs and potential margin calls or asset sales.
Why do Japanese investors buy U.S. treasuries, and how does the cost of hedging influence this?
Japanese investors buy U.S. treasuries to benefit from higher yields, but the cost of hedging from yen to dollars is a significant factor. When the cost of hedging is high due to higher U.S. interest rates, it reduces the attractiveness of U.S. treasuries for Japanese investors. If the Fed cuts rates, it could lower hedging costs and incentivize more Japanese purchases of U.S. bonds.
- Interest rates have fallen, with three cuts in two meetings.
- The upcoming election introduces significant geopolitical and financial uncertainty.
- The Fed's approach is described as 'wait and see'.
- Debate on whether the Fed will cut rates in December hinges on upcoming data (PCE and NFP reports).
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