Fedguy.com Joseph Wang joins Yahoo Finance Live to discuss the Dow dropping below 700+ points and the expectations for the Fed’s rate hike meeting.

Video Transcript

- Let's take a look at markets as we are 15 after the hour here on the East Coast. We're taking a look at the Dow down 2.5%, S&P 500 down 3.5%, and the NASDAQ down 4.2%. A nasty sell-off, this two days before the Federal Reserve's much-anticipated announcement.

Again, we're expected to hear from Fed Chair Jay Powell at 2:00PM on Wednesday. Another 50 basis point hike on the table. That remains the expectation.

But of course, with all the choppiness in the market, the question is, will further Fed rate hikes rock the boat further? Joining us now to break it down, former New York Fed official Joseph Wang a.k.a. FedGuy12 on Twitter. Great to have you on the program, Joseph. Just kind of want to kick things off by asking about what your expectations are for the Fed as they continue this firefight with inflation.

JOSEPH WANG: Hey, Brian. First of all, thank you for having me. Pleasure to be here.

So as you noted, the market expects 50 basis points, although there is some expectation priced in for a 75 basis point hike. So from what I understand about the Powell effect, first rule, do not surprise the markets. So as Powell has been noting, 50 basis points. Heading up to the meeting, I expect him to do 50 basis points.

That being said, and as we can see pricing to the markets, the terminal rate for the Fed funds is moving higher. So what I expect is the Fed to actually do 50 basis points this week, but to slowly guide the market toward a higher terminal rate. And potentially, a more rapid pace. So they're going to keep the possibility of doing a 75 basis point or more hike in future meetings.

- Yeah, and it seems like really, the big-- sorry, I just kind of wanted to ask for a little bit elaboration on that. Because I guess we've heard from the Fed that they're going to get 50 basis points in this meeting. 50 basis points again in the July meeting. Which some might argue, did they paint themselves into a corner by promising that commitment? So when you say they're going to promise maybe a higher terminal rate, either through that plot or just through the press conference, does that imply that you see those more aggressive rate hikes happening in the later meetings that they haven't committed to or actually changing the course for perhaps even July?

JOSEPH WANG: So July is in the future. I think it would be fine for Powell to guide or at least open up possibility of larger rate hikes above 50 basis points. Opening up the possibility for 75 in a future hike. I think if you were to make the comment that maybe there could be a 75 in July, I think that's early enough. So that would be enough time for the market to adjust.

But really, the more important tool that the Fed has is for guidance. And so it's being able to guide the markets towards either, let's say, a redefinition of neutral. Towards something, let's say, higher than 2.53%, which Powell has been noting, which would be more reasonable.

As you know, the neutral rate is a real rate of 50 basis points, but you have to add inflation to that to get a nominal rate. Now inflation is rising. And inflation has different time frames, right?

So it would be totally reasonable for him to take that angle to guide towards a higher neutral rate. And that would automatically shift the path of policy to a more restrictive stance. Alternatively, instead of saying that we're going to get to neutral quickly, Powell can simply say that we're going to move towards restrictive monetary policy. Which would totally make sense since inflation is quite high.

- Joseph, we're continuing to see steep declines today on the back of that inflation print that we got on Friday. And I heard you say recently that you think the market just is underestimating what exactly the Fed needs to do when the rate is at 8.6%, the headline number there. I mean, in the simplest terms, what should investors be bracing for?

JOSEPH WANG: I think that investors expect a terminal Feds funds rate markedly higher than, let's say, the-- if we're pricing in at just below 4% as a terminal rate, I think the market should expect higher terminal Fed funds. The reason being is, you have to look at this from the Fed's perspective. The Fed looks at the world through the lens of the neutral policy rate. Neutral being 50 real basis points.

You have to add inflation onto that to get to a neutral nominal rate. So inflation is pretty high. And you have to go above neutral if you actually want to be restrictive in your monetary policy.

So if inflation is, let's say, 4% in the medium term, you add 50 basis points to get to 4.5% as a neutral nominal rate. You have to go above that to be restrictive. So you can easily see our Fed funds rate 5% or above.

And we have other officials. Let's say, Larry Summers or Bill Nelson, former senior Fed official, also echoing similar sentiments. I think that's actually very reasonable given the dilemma that we're in right now. The market's not pricing that. Eventually when it does, I expect that there would be a lot of volatility going forward.

- Joseph, another thing that people seem to be forgetting about is that this is the first month-- again, about two weeks ago-- that the Fed has begun actively shrinking its asset holdings on its balance sheet. Nearly $9 trillion. It's letting some of those maturities, a lot of the mortgage-backed securities in US treasuries, roll off. How do you think that's impacting what we're seeing specifically in rates right now? And is that helpful or harmful to what the Fed's trying to do here on inflation?

JOSEPH WANG: That's a great point, Brian. So the Fed is not only tightening the overnight rate and guiding forward, but it's also engaging in quantitative tightening starting this month. So in my view, quantitative tightening does two things. One is increases the supply of treasuries, increases the [INAUDIBLE] supply of duration into the market. And the other thing is that it's sucking liquidity out of the market.

So going forward, if you look at public sector projections, the private sector, the market, is going to have to digest about $1.5 trillion in treasuries this year and the next year. And that's historically quite high. So I expect that to push up term premia as we go higher.

So that's going to put upward pressure on longer dated rates. I think the market is trying to price that in, but it's really hard to price in. The reason being that right now, we have a change in who's a marginal buyer in rates.

Before 2020, it was the hedge fund community. After 2020, it was the Fed and the commercial banks. And right now, the market has to go through a price discovery process where we figure out who the next marginal buyer is. And I think that might be disruptive. And it's going to put further upward pressure on longer dated rates.

Now the second part about withdrawing liquidity. Now that's actually the worst time to be doing this right now. And as we discussed with Steve just a few minutes ago, everything is getting sold. And another way to look at that is that everyone is grasping for cash.

Now it's in this context that what the Fed is doing is that it's kind of taking out the cash in the system. So everyone is grasping for a pool of cash that is shrinking. So that to me suggests more volatility going forward.

And one last thing I would like to add is that it's not just the Fed that is withdrawing liquidity out of the system through quantitative tightening. If you look at the Fed's reverse repo facility, it's climbing. It's recently up to $2.1 trillion. I expect it to go much higher.

And that's another drain in the system that I don't think the Fed anticipated. If you look at their speeches, they were anticipating QT to go quite smoothly because of what's in the RP. Expecting that the liquidity they drained would come out of the reverse repo facility.

But that's not happening at all. The reverse repo facility is an additional drain. So what you're going to see in the next six months is that you have tightening from the Fed guiding higher.

You have tightening from quantitative tightening raising the term premia. And you have tightening from withdrawing liquidity. So I think that it's going to be quite interesting to see how things develop in the coming months.

- Yeah, good context there ahead of the Fed meeting. Of course, everybody will be watching. And Joseph, we hope to have you back on the show again soon. Joseph Wang of Fedguy.com. Thanks so much for joining us today.