The Fed Can Use the “Alphabet” If Need Be

By Jeff Weniger and Kevin Flanagan

The month of April will unfortunately go down in financial market folklore as being one of the more noteworthy on record. While tariff-related uncertainty created large swings in risk assets, such as the equity markets, it has been the volatility exhibited in the U.S. Treasury (UST) market that has come as a surprise. After serving their traditional role in the flight-to-quality trade, Treasuries—more specifically, the back end of the yield curve—have sold off in a visible fashion.

There are a variety of reasons being floated around for this behavior, and we may not know the exact answer until later this year. In our opinion, it is a confluence of factors coming together all at the same time; namely, a reversal of the safe-haven bid, unwinding trades that were positioned for further rate declines and selling to raise cash are all a good place to start. There has also been conjecture of a potential retaliatory liquidation of Treasuries by China, but there is no concrete evidence of such a trade. In addition, given the size of Chinese UST holdings, one could argue that it would be counterproductive due to the likely end result of realizing losses. Could global investors be choosing other sovereign bond markets for their funds as a repercussion of the tariff announcements? Another possibility that can’t be completely ruled out, at least from a short-run perspective.

Needless to say, in the age of rampant social media and speculation, many pundits are coming out and saying the Fed may have to step in at some point. And this is the focus of this edition of Minds on the Markets…putting things in a proper perspective.

Perhaps the most important thing to remember is that when it comes to monetary policy, the Fed views developments from two lenses. The first involves the macro, or its dual mandate of employment and inflation. On this front, the data to end Q1 was a welcome development, as the March jobs data was relatively solid, and the CPI report revealed some disinflation.

That leads us to part two of the equation: market-related considerations. The Fed’s preference is to utilize rate cuts more for the macro/dual mandate aspects of policy. For market-related turbulence, the policy maker can turn to its balance sheet. As we witnessed during the financial crisis, and more recently with COVID-19, the Fed has a variety of different facilities at its disposal to help mitigate issues in the money and bond markets. Remember, the key here is for financial and non-financial companies to be able to fund themselves. While there has been some tightening up in conditions in recent trading sessions, there is not any sign of worrisome funding pressures at this point. That being said, this is where the Fed can turn to its “alphabet soup” facilities it has used with success in the past.

What other policy measure is at its disposal? Perhaps its best-known tool: buying Treasuries, a.k.a. quantitative easing (QE). The policy maker just recently pulled back on its current quantitative tightening (QT) program, and as a first step, it could end it altogether. If need be, the Fed could completely reverse course and then implement QE. Interestingly, one could say that ending QT completely could be akin to a rate cut of sorts, and then restarting QE could serve as another.

Our advice is to stay tuned and try not to get too caught up in the day-to-day headlines and tweets that are out there because this is going to be a very fluid situation.