Can Warsh get markets to play the ball, not the referee?

Federal Reserve (Fed) Chair Kevin Warsh hosted his second Federal Open Market Committee (FOMC) meeting this week, with most people, including ourselves, expecting a hawkish hold. For markets, however, the main focus was on the press conference where they hoped to obtain useful insight into the Fed Chair’s thoughts on the economy, neutral rates, reaction function and more.

We did not get that. As he put it, "market participants are learning to play the ball, not the referee". In football (we mean soccer!), players assess how a referee officiates a game and adjust their behaviour accordingly. Some referees are more lenient, others apply the rules more strictly, but all referees have a style. Players have understood since Chair Warsh was appointed that there is a new referee in charge, and they have been willing to play more cautiously while they work out his style. But there is a big risk that the referee loses control of the game, and things get out of hand if the uncertainty about how the rules will be applied remains the case for too long. This might not be a "family fight" but a proper one!

30-year yields made their displeasure with the referee known yesterday, rising by around 10 basis points (bp) on the day. The short end of the curve rallied, as markets had priced in some probability of a rate hike, which ultimately did not materialise. However, it gave back part of the gains, ending the day 4bp tighter. The 10-year part of the curve was unchanged at some point after the decision, but a late selloff took yields some 6bp higher by the end of the trading session.

As noted by Warsh in his opening remarks, "both nominal and real yields are materially higher" since the last FOMC meeting, which he regarded as a good thing, as markets are internalising real data in real-time, whilst he also acknowledged that the lack of forward guidance might have played a role. While we get the point, we think there is a chance that markets tell him they need more clarity on his reaction function and his thoughts on the economy via a steeper curve. Markets do not like uncertainty, and less guidance from the Fed can increases it, and when faced with too much of it, investors often demand a higher premium.

Interestingly, this premium has come in the form of higher real yields while inflation expectations have remained well anchored. The five-year inflation breakeven, calculated as the difference between the five-year nominal UST and the five-year Treasury Inflation-Protected Security (TIPS), currently sits at 2.27% and has declined markedly from recent highs. Five-year TIPS yields, however, have moved from 1.2% in late April to 2.12% at the time of writing. This could be a byproduct of higher growth expectations due to the artificial intelligence (AI) investments, but we note that Bloomberg consensus for the next couple of years currently sits at 2.1%, hardly spectacular, and has not moved much since April.

We believe that at least part of this move higher in real rates is due to the new Fed's lack of clarity and for the possibility of material changes coming from the task forces that were announced some weeks ago. All of this is also not helped by the enormous supply and fiscal deficits in the US. We also note that some albeit, not all, measures of term premium have also increased slightly. These measures of term premium are based on statistical models, and we acknowledge that the term premium cannot be observed directly. Nevertheless, to see some of these moving higher is consistent with a more uncertain environment to which the Fed is contributing by not communicating clearly how they see the economy and monetary policy evolving.

Regarding fixed income markets and valuations, US Treasury yields have increased, and they look optically attractive. While we reward these higher yields with an allocation to US Treasuries in our portfolios and a neutral to slightly longer than neutral duration stance depending on the mandate, we are not too tempted to increase duration further at these levels. With the probability of a recession remaining low, and solid corporate fundamentals, we see no reason to change our preference for credit over government bonds at this stage. We also take note that the European Central Bank (ECB) does not have to deal with many of the problems previously mentioned, including a potential demand side boost due to AI infrastructure, and we therefore favour diversification away from US Treasuries into European exposures in our government bond allocations.

And to wrap up with the sports analogy, in football, the best referees are the ones you barely notice: they set clear instructions, apply rules consistently and intervene when needed, but let the game flow. The worst officials can hand out lots of cards and ruin the spectacle with a stop-start game. What type of game is Warsh seeking to referee? Until markets can gauge his style, we may see increased uncertainty with a demand for higher premiums.