One week / one topic: Sea change

What happened?

The new Fed Chairman Kevin Warsh doesn’t want to say (too) much.

However, soon he might not have a choice anymore…

On Wednesday, the Fed left interest rates unchanged for a seventh consecutive month despite internal dissent towards a hike and growing concerns about missing its own inflation target for five years in a row.

While Warsh’s intention to do away with forward guidance and letting investors do more of their own homework might be laudable, market would have none of it on Wednesday.

The more he spoke during the press conference, the more the US curve steepened.

Without even trying to resist the urge to personify 2yr and 30yr bonds (I know), this is how the US yield curve reacted:

• 2yr bonds to Warsh: “We don’t believe you. You are a dove in disguise, and we are going to price in more cuts no matter what you say!”

• 30yr bonds to Warsh: “We don’t believe you. You’re playing with fire by not raising rates now, and you will be forced to hike more in the end!”

The result was a monumental steepening of the US yield curve, with 30yr yields reaching levels last seen in 2007.

In the end, what arguably should have been a routine meeting became instead a dominant macro event, as investors focused less on the Fed's decision and more on growing uncertainty around its reaction function and communication strategy.

What should we make of it?

Our observations

• Fundamentals: The Fed reaction function is indeed of fundamental importance to asset pricing of all stripes.

  To boot, three Federal Open Market Committee members dissented – for only the sixth time in 30 years– adding to the confusion about what’s going on internally.

• Price action: The intraday price action left an unmistakable tell as to what investors didn’t like.

  Once Warsh started speaking, the initially calm reaction to the rates decision quickly gave in to a very rapid repricing across assets.

• Investor beliefs: Turns out that silence is not a good communication strategy when catering to investors used to policymakers holding their hand at every occasion.

  Consequently, markets are now pricing a ~65% chance of a hike in September. Unintended consequences, anyone?

So what?

Warsh’s choice (not) to communicate in this manner really stands out.

First, this was an action-packed week with several major central bank meetings (Fed, BoE, BoJ), key economic releases (US Q2 GDP) and mega cap earnings announcements.

While deciding not to massage things too much with such a backdrop sends a strong message, you also take a big risk when doing so.

Secondly, we are by wide consensus operating in unprecedented territory (twas ever thus…), given the gargantuan impact of the AI race.

It is already difficult enough to derive a fair value for long-dated bonds in normal times… introducing additional uncertainty at such a radically uncertain time seems a bit like tempting fate?

As acutely observed by Cameron Crise on Bloomberg (below), markets are indeed interpreting this like a big, intentional policy shift – which might well have been the original goal.

But maybe not this time around, given that the move had been almost the exact opposite the previous (and first) Fed meeting led by Wash in June?

The jury is very much out on this one, but perhaps this can engender the very sort of sharp repricing opportunities that we tend to look for.

Stay tuned…

Mood music: Sam Cooke – A Change Is Gonna Come

By popular demand, here is the One week / One topic playlist

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