Wrong man, wrong time, wrong job

At Tricio we look at charts in order to gauge investor sentiment and behaviour. Right now the US 30-yr. bond yield and 10 and 2-yr. note yield charts suggest that investors are weighing Fed Chair Warsh and finding him wanting. Wrong man at the wrong time and potentially in the wrong job.

Fed Chair Warsh delivered a ‘no change’ rate decision yesterday, as we expected, but the bond market was left feeling a bit let down with yields in the US 30-yr. bond yield (chart below, bottom) hitting new cycle highs above 5.2% after the press conference. The 10-yr. note yield (chart below, middle) is looking as if a push to 5% and higher is just a matter of time and the 2-yr. note yield (chart below, top) is holding 50+ bp above the fed funds rate these days, signalling the market suspicion that the Fed has got it wrong.

After two meetings as Fed Chair, the bond market seems to be suspecting that there is a chance that US President Trump picked the wrong guy to lead the Fed. This is the wrong time for an intellectual exercise in Fed obscurity and Kevin Warsh is actually in the wrong job given the bond market reaction.

Things may get better though as markets tend to give new Fed Chair’s a bit of time to adjust their seats and get comfy. Fed Chair Greenspan was in the job for two months before the stock market crashed in October 1987 and he managed to rise to the occasion. Right now, with bond yields suggesting that the Fed has got it wrong, do we wait and see if the Fed’s ‘reaction function’ becomes clearer in time?  

The Wikipedia page for Fed Chair Walsh lists an impressive resume. Being a bit harsh, I have to admit I don’t remember his activities during the crisis as we focused on Fed Chair Bernanke, Treasury Secretary Paulson and FDIC Chair Blair. The fact that Warsh seemed to object and then resign over the Fed’s QE plans in 2011 suggest that he is not the ‘easy money’ guy that Trump wants as Fed Chair.

However, in his first post-Fed meeting press conference as Chair in June Warsh seemed to go out of his way to rubbish the forecasting efforts of his fellow FOMC members. Yes, he was and is trying to wean the market and Fed watchers off the view that the Summary of Economic Projections were forecasts. However, former Fed Chair Powell always said that they were not forecasts. I doubt that any financial institution or investor took the SEP as being more than the summary of the best guess efforts taken at the time. The view has been for many years now that the Fed would bend policy to adjust for incoming data as needed (data dependency). In that sense, not a lot has changed except if I were one of the FOMC members contributing my best guess forecasts, I would be a bit cheesed off to have my efforts publicly ridiculed to the point that Warsh has in his last two press conferences.  

By stressing at last nights press conference that he wants the markets to adjust rates for themselves but still talking about how tough he will be on fighting inflation, Warsh is putting himself (and more importantly, the Fed, the US bond market, the ability of Treasury to issue bonds at a reasonable rate and the USD, stock markets, the free world economy etc.) into a bind. The question after last nights press conference was ‘why didn’t you vote to raise rates at this meeting then?’.

Warsh may walk the talk and argue for and actually tighten policy a lot at the next few meetings. He has pointed out that the Fed has missed their inflation target for over 5 years and the current pace of inflation is above target as well. We suspect he won’t though because he knows that raising rates won’t help at all when the chief culprit for bond market yields and inflation rising is the worry over energy costs and second round effects from the US war in Iran. Would a return to a 5.25%/5.5% fed funds rate do anything about this?

True, he could push the fed funds rate up to 8%, squeezing the US economy until the pips squeak (apologies to Mrs. T) and hope that the deep recession that would likely follow would pull inflation readings down a lot. But what is the point of a cure if that is worse than the disease? 

We suspect that Fed Chair Warsh is trying to be too clever. By letting the bond market tighten for him with higher bond yields he can tell Trump ‘look, I haven’t voted to raise rates!’ and hope that the US war in Iran ends soon (a sustained ceasefire would do…). Energy prices would likely fall hard again and inflation risks would subside.

Even if inflation risks do subside, a case can be made for rate hikes in 2027. For example, US economic activity seems oddly unbalanced as AI spending/infrastructure investment over the last few years is thought to have helped avoid a slump in growth, boosting GDP by 1% or more. If the AI bubble gets bigger and growth picks up further and the labour market tightens to the point that workers get shirty again and ask for pay rises, then the Fed may hike rates to dampen their hopes. In other words, a normal cycle, with a potential ‘pop’ if the AI bubble bursts at some point.

Right now though Fed Chair Warsh may be playing a dangerous game. If the bond market truly believes that he can’t (or won’t) raise rates and inflation will run hot then brace for 6% or 8% sort of yields in the 30 and 10-yr. bond yields. This won’t help the USD as FX traders like high yields, but they don’t like high yields if the central bank is behind the curve and looking to stay there.

Trump backed Warsh yesterday, calling him ‘brilliant’. At some stage one of Trump’s minions will have the horrible job of letting him that mortgage rates are rising again. With midterms approaching the higher cost of borrowing to buy a house won’t help Republicans.

Solution? Warsh should quit grandstanding at the press conferences and talk sense. Try saying that tariffs didn’t help inflation readings and won’t help much going forward. Talk about hopes for an end to higher energy prices which will give bond markets a respite. And whilst avoiding forward guidance, stress that the Fed is data dependent but not stupid. If hiking rates in order to quell rising energy prices is a possible policy mistake, say so. Tell the market that if need be, rates will go up, but then warn the market that this means the brakes are being hit (not just a punch bowl being taken away) as the math involved in slowing the US economy down to the point where higher energy prices don’t cause second round effects and higher inflation readings would suggest a pretty big hit to GDP would be required.

US 2 yr note yield

US 10yr note yield

US 30yr bond yield

Gerry Celaya, Chief Strategist