Did the Markets Corner Warsh?

It’s always a bit tricky to write pieces like this just hours before an FOMC meeting, since there is a very good chance that you will be reading this after the decision is announced.  Coming into the event, it seems as though a 25-basis-point hike is a fait accompli.  Futures are pricing a 93% chance for a hike this afternoon (though IBKR Prediction Markets show “only” a 88% “Yes”), and it is exceedingly rare for the Fed to shock markets with unexpected moves unless they feel they absolutely must.  But does the Chair want this hike now?

For several weeks I held the belief that Chair Warsh, if not several members of the Federal Open Market Committee, would be loath to raise rates with the midterm elections looming.  While he was a notable hawk during his term as Federal Reserve Governor, Warsh was appointed by a President who craves lower rates – advocating for them as recently as last weekend despite copious economic evidence that such a move would be unwarranted at best and detrimental at worst.  During the process prior to his nomination, it seems logical to think that Warsh must have assured the President that he was at least sympathetic to his views.  It was probably inevitable that at some point an inflation-fighting Fed Chair would draw the ire of a rate-cut-oriented President, but it seemed as though Warsh was not itching for that conflict yet.  After some veiled threats from the administration over the weekend, National Economic Council Director Kevin Hassett said on Tuesday that the President would “respect the process and understand that he [Warsh] is doing what he and the committee think is correct.”  We’re likely to learn if that will truly be the case soon enough.

Failure to meet market expectations for a hike today could be potentially catastrophic.  We’ve all watched the steady rise of long-term rates, not only in the US, but globally.  While there are several factors that influenced those moves, one of them is concern about rising inflationary expectations.  A Fed that continues to talk tough about inflation but fails to follow through on that message risks losing credibility.  An already jittery bond market would punish a “talk tough, no action” Fed, and even though stocks have been able to shrug off the move in 10-year rates from 4% to 5%, it’s not clear that stocks could remain immune from another sharp lurch higher in yields.  Thus, it seems reasonable to take the low probability “no hike” option off the table today. 

Therefore, let’s focus on the far more likely outcome of a 25-basis-point hike.  Stocks and bonds seem to be quite ok with that prospect this morning, with the S&P 500 (SPX) rising by about 0.4% and 2-year and 10-year yields each falling by about 5 basis points.  While we continue to see near-certain expectations for hikes today and in December, fixed-income markets have pushed back expectations for a third hike from March to April and have reduced expectations for a fourth hike around midyear to about 50 percent from near-certainty.   If the markets get what they want, they tend to act favorably.  (Reports about the Saudis reopening a pipeline are helping too.)

The stakes are high, though, for Warsh’s press conference.  The Chair has made it quite clear that he favors less communication over greater transparency, but that means, somewhat paradoxically, that the stakes are higher each time he does speak publicly.  Stocks have not responded favorably after his first two pressers – SPX fell 1.2% after the June meeting and 1.5% after July’s – so the post-meeting reaction will hinge less upon the seemingly pre-determined outcome of the FOMC meeting and more upon whether Warsh seems truly committed to fighting inflation, what metrics he prefers, and how quickly he is likely to advocate for future actions. 

Warsh has so far talked a big game about fighting inflation during his short time in office but so far has done nothing concrete to back it up.  Today, action is expected.  The nature of that action and its intended follow-up will be the key influences affecting stock and bond investors’ decisions in the days and weeks to come.

Source: Interactive Brokers