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Kevin Warsh’s push to axe Fed guidance may lift US borrowing costs, investors warn
Traders see more volatility ahead as new central bank chair declines to give dot plot on future path of interest rates
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Kate Duguid and Amelia Pollard in New York and Claire Jones in Washington
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Kevin Warsh’s push to axe the Federal Reserve’s guidance on the direction of monetary policy could increase volatility in the Treasury market and drive borrowing costs higher, major investors have warned.
At his first Fed meeting as chair on Wednesday, Warsh said his tenure marked “a new chapter” for markets, in which the central bank would remove parts of its forward guidance — ditching some of the vital tools it has been using to point investors to where interest rates are heading.
Without a clear steer on the world’s most important central banker’s expectations for rates, investors say markets are likely to become more volatile and undergo bigger swings around the Fed’s decisions. US borrowing costs could also rise as traders demand more of a premium to offset the increased uncertainty about rates.
“I don’t like it because I don’t see the benefit of less transparency, which is where this seems to be headed,” said Bob Michele, chief investment officer and head of the global fixed income, currency and commodities group at JPMorgan Asset Management.
“Of course less transparency means more guesswork, more uncertainty, more volatility, more risk premium, more event risk,” he added.
In a slimmed-down statement on Wednesday accompanying the Federal Open Market Committee’s decision to leave borrowing costs on hold, rate-setters removed a longstanding signal on whether they had a bias towards easing or tightening monetary policy in the coming months. Warsh also declined to submit his “dot plot” for where he sees interest rates heading this year and next. While the other 18 officials did, the absence of the chair’s prediction weakens the dots’ usefulness as a guide to Fed policy, say investors.
While the new Fed chair acknowledged the revamp was “a lot of change for financial markets to digest”, he signalled he was unlikely to reverse course. A task force would be set up to look into further changes to the guidance, he said, suggesting the central bank could scrap the dot plots entirely.
Warsh has previously said he believes dot plots and other forms of forward guidance leave the Fed clinging to its forecasts and doubling down on policy errors. On Wednesday, he said markets had come to rely on central bankers’ guidance to such an extent that it created an echo chamber in which prices were more likely to reflect the Fed’s views than investors’.
The benchmark 10-year Treasury yield, which moves inversely to prices, has risen 0.5 percentage points since the start of the Iran war on expectations of higher inflation and interest rates. The Fed’s hawkish tilt this week has driven two-year yields, particularly sensitive to monetary policy, up to 4.22 per cent, the highest level in more than a year. Some investors see room for a further uplift based on the central bank’s new approach.
“Markets are now more prone to surprise . . . and should both price in more risk premium for hikes and more volatility going forward,” said Calvin Tse, head of strategy and economics at BNP Paribas.
Investors say that premium had not materialised in the days following the meeting probably because broader changes are still under consideration by the task forces Warsh set up. However, Tiffany Wilding, an economist at bond fund giant Pimco, said she expected “notable changes” from them, “including fewer press conferences, less prescriptive communication, more willingness to surprise bond markets and ultimately more rate volatility”.
Forward guidance rose to prominence in the era of zero interest rates following the global financial crisis. With short-term borrowing costs as low as they could go, central bankers sought ways to boost inflation and growth by influencing longer-term rates.
Former chair Ben Bernanke introduced interest rate dot plots in 2012 as a means to signal the central bank was likely to keep rates close to zero for years to come. But, with rates now much higher, many have questioned their usefulness.
However, Pramod Atluri, a portfolio manager at Capital Group, said that while Warsh’s changes would increase volatility in the market and raise borrowing costs, that may be helpful for the Fed.
“If you create too much certainty in the market, you eliminate volatility and you encourage risk-taking and speculation and leverage into the system,” Atluri said.
More volatility and higher bond yields make leverage more expensive and tighten financial conditions for companies and individuals. The ultimate effect of that could be to reduce inflation.
In addition, some see the ability to shock markets as valuable because it means the Fed has more sway over prices and can better transmit policy.
Rick Rieder, chief investment officer of global fixed income at BlackRock, said there should be “an asymmetry”, or imbalance of power, between the central bank and markets.
“When you’re easing monetary policy, you want the art of surprise. You want animal spirits moving,” he said.
Macro hedge funds, which bet on moves in bonds, currencies and other assets around the world, are one group that believes they could benefit from a new era in which the Fed says less.
Without interest rate changes telegraphed long ahead of time, investors can gain an edge if they can predict what the central bank might do next. At a recent dinner in New York with several macro portfolio managers, most agreed Warsh’s new approach to communication would drive up market volatility, one attendee told the FT, which could help their trading.
“This seems like a Fed that’s going to be trying to manage the market a lot less, and that could mean structurally higher volatility,” said Kelly Tropin Whitridge, chief economist at Graham Capital, a macro-focused hedge fund in Connecticut that manages $21bn in assets.
“People of course have continued to trade the front end, and it’s been a big feature of what we do,” she added. “But it could be an even greater focus now.”
Additional reporting by Ian Smith in London
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