Last year, I wrote an article expressing my belief that we should not easily bet on the Federal Reserve’s quick interest rate cuts, but instead be cautious about the possibility of a rate hike to some extent.
Since then, I have not written any articles speculating about the Fed’s policies because the market has been filled with optimistic discussions about rate cuts, which contradicted my viewpoint.
However, the change in market sentiment since then has been quite interesting. From initially optimistic about a rate cut soon (some said in December last year, others said in March this year…), the topic of rate cuts in the first half of the year is hardly mentioned anymore.
The reason why the market sentiment has become so irrational was something I shared in a Twitter exchange at the beginning of the month: many articles and opinions discussing rate cuts in the market are irrational and emotional, lacking even some basic logic.
I have previously said that the Fed’s policy is not a “conspiracy” but a “strategy.” In other words, unless there is a black swan event, the Fed will act transparently according to its own publicly established rules. Even if they want to play some tricks, they will do so openly and not engage in senseless drama.
What does it mean to be open and transparent? It means that they will openly share their views and thoughts, and whether readers can read between the lines depends on their own abilities.
However, 99.99% of the articles in the market cannot read the “subtext,” so they can only speculate and make bets.
Today, I want to share an article that provides a high-quality interpretation of the Fed’s (future) intentions (link to the article provided at the end).
This article interprets a speech by Christopher J. Waller, a member of the Federal Reserve Board, titled “Some Thoughts on r*: Why Did It Fall and Will It Rise?” given on May 24th in Iceland. The full text of the speech is publicly available on the Fed’s official website for anyone to read.
Currently, the US market generally believes that Trump has a high chance of winning the election at the end of the year if he is not negatively affected by legal issues. If Trump is elected, it is believed that Waller is likely to succeed Powell as the next Chairman of the Federal Reserve.
This speech by Waller is his thinking on the current interest rate policy in the United States, and it can help us glimpse the possible direction of the Fed’s future policies.
Before introducing the analysis of this article, let me share two preliminary points of knowledge:
1. The relationship between Treasury bond yields, prices, and coupon rates.
2. The difference in governing philosophies between the Democratic and Republican parties in the United States.
I have previously written an article specifically introducing the relationship between Treasury bond yields, prices, and coupon rates.
In summary, the coupon rate of a Treasury bond is fixed. However, once the bond is listed, its actual yield is not closely related to the coupon rate but is closely related to the trading price of the bond. The higher the trading price, the lower the actual yield, and vice versa.
However, when the government issues new Treasury bonds, the coupon rate of the new bonds becomes closely related to the actual yield of existing traded bonds. If the actual yield of existing bonds is very high, it would be meaningless to set a low coupon rate for newly issued bonds because they may not be bought or may be forced to be issued at a discount.
Therefore, if the expectation is for newly issued bonds to have low coupon rates and be successfully issued, the actual yield of existing bonds cannot be high. How can we control the actual yield of existing bonds to not be too high? One important market mechanism is to reduce the supply of Treasury bonds on the market, driving up their trading prices and lowering their actual yields.
Now let’s look at the difference in governing philosophies between the Democratic and Republican parties:
The Democratic Party has always advocated for big government, believing that a big government has enough power to ensure fairness, help the weak, maintain social stability, and promote healthy development.
The Republican Party’s philosophy is that the government only needs to focus on maintaining order, regulation, legislation, law enforcement, and other basic tasks, while other matters should be left to the market. They believe in unleashing the market’s vitality and creativity. An overly powerful government directly results in a bloated bureaucracy, inefficient bureaucratic systems, and ultimately leads to the breeding of corruption and abuse of power, disrupting the free market and hindering its self-regulatory function.
The philosophies of the two parties translate into fiscal policies as follows:
A Democratic government needs to establish more institutions, employ more civil servants, manage more things, and intervene more in market operations. All of this requires more money. The most direct way to obtain money is to issue more Treasury bonds, which increases the supply. The direct consequence of this is to force down the trading price of Treasury bonds and increase the actual yield.
On the other hand, the Republican government is the opposite. They aim to reduce unnecessary government institutions, lay off unnecessary civil servants, and minimize unnecessary government intervention. This naturally reduces government expenses and the need to issue too many Treasury bonds, thereby reducing the supply of bonds, increasing their trading prices, and lowering their actual yields.
Of course, the situations listed above are ideal scenarios. The current Democratic and Republican parties in the United States are not 100% classic in these regards. However, they still maintain significant differences in some basic principles and policy ideas, which lead to evident policy differences.
Now let’s look at the analysis of Waller’s speech in this article.
In the Fed’s recent public discussions, they often mention the need to control the “neutral interest rate” at a certain level.
What is the “neutral interest rate”? Waller uses two indicators to measure it: the actual yield on 10-year Treasury bonds and US inflation-protected bonds.
The conclusion drawn from the analysis of Waller’s speech in this article is as follows:
“What Waller really wants to express is that the current neutral interest rate in the US is continuously rising, primarily due to the excessive supply of Treasury bonds. This also explains why the Fed has been hesitant to cut interest rates. In simple terms, since the neutral interest rate, which is a reasonable benchmark, is rising, it would be unreasonable to lower the policy interest rate now. If we want to lower the policy interest rate reasonably, we must first lower the neutral interest rate, which is currently being pushed up by the continuous issuance of Treasury bonds.”
“Or to put it more bluntly, what Waller is trying to convey is that if the left-wing Democratic Party is in power, Treasury bonds will inevitably be excessively issued, the neutral interest rate will rise, and the Fed will be hesitant to cut interest rates. Only when the right-wing Republican Party is in power can Treasury bond issuance be reduced, the neutral interest rate can decrease, and the Fed can confidently and continuously cut interest rates.”
This analysis reads the “subtext” of Waller’s speech.
Does this mean that the Fed will not cut interest rates before the election this year?
On this point, my understanding differs slightly from the analysis in this article.
I don’t think so. It only expresses the future potential Fed chairman’s true views on interest rates and the measures he may consider taking:
If we want to cut interest rates cleanly, reducing the supply of Treasury bonds may be a very worthwhile measure to consider, in addition to other policy measures.
So, we can now carefully observe whether the US government will move in this direction.
