The quip, “if you aren’t confused, you aren’t paying attention” needs to be replaced: “with the Fed confused, you better pay attention.” You may want to buckle up. Let me explain.
It all starts with the Fed...
In assessing our crystal ball for 2019, the starting point is the Federal Reserve (Fed) because they provide an anchor for the price of risk-free assets (Treasuries) around which risk assets are priced.1 When rates were near zero and the Fed purchased Treasuries, it wasn’t only Treasury yields that were depressed, but the Fed pulled down yields of risk assets as well. Differently said, the Fed made it appear as if risky assets were less risky; this didn’t only affect bonds, but also equities that enjoyed years of rising prices on the backdrop of low volatility. This was the era of compressed risk premia.
Part of the rise in risk premia in 2018 was a direct result of rates moving higher; that said, volatility has come back with a vengeance. Historically, in our analysis, an extended period of low volatility (remember the goldilocks-years ahead of the financial crisis?) is often followed by an extraordinary surge in volatility. As such, to an extent, the elevated volatility we see now is to be expected. Possibly it is also related to algorithms dominating some markets; and/or geo-political events. But could it be that the Fed’s transition from FOMC to FOFC has something to do with it?
FOMC becoming FOFC?
The Federal Reserve Open Market Committee (FOMC) is the body that, under the leadership of its Chair Jay Powell, sets the Federal Funds Rate. The FOFC, in contrast, is the Flip Or Flop Committee. The FOFC appears to be a secret body, as I have yet to see any announcement that it has formally been established. Yet, judging from Fed Chair Jay Powell’s comments in recent weeks, it may have displaced the FOMC.
Joking aside, the Fed had been on a set course to let its large Treasury holdings run off (engage in so-called quantitative tightening or “QT”) and to raise rates. Until last summer, Powell had made it clear that even with the higher rates, the Fed was still “accommodative”; in December, after the 4th 0.25% rate hike of 2018, the FOMC statement stated that the interest rates had now reached what some at the Fed considered to be neutral, implying rates would need to move higher – especially since he had indicated a few months earlier that rates may need to move above neutral. He had also suggested not to touch the QT program, so as to not to confuse the markets with multiple policy tools.
Fast forward and it’s a different story: in a recent panel discussion, Powell implied the path of quantitative tightening is not set in stone, and the Fed would be flexible. Similarly, Powell suggested the Fed can be very flexible, even lower rates on short notice should it be required. What???