Kevin Warsh has been installed as the new chairman of the US Federal Reserve and investors are assessing what they should expect from the new chief, who has been critical of how the US central bank conducts monetary policy.
Much has been made of the threats to the Fed’s independence during the tenure of Warsh’s predecessor, Jerome Powell, with increased pressure from the White House for accelerated rate cuts.
However, Warsh is committed to the independence of the Federal Reserve Open Market Committee – under his leadership, the rate-setting body will, in operational terms, remain free from political interference.
But his reassurances need to be balanced against his persistent criticism of the central bank.
Warsh has deep reservations about several aspects of the Fed’s approach to setting interest rates, from the inflation data it uses to the way in which it provides rate forecasts.
This suggests to me that monetary policy could end up being influenced by the government’s spending, growth and trade priorities. And if bond investors believe this is the case, they may demand a higher risk premium on US government debt.
This could result in a steeper bond yield curve, an increase in the US treasuries’ term premium and a more volatile US dollar.
Changing inflation gauges
When it comes to measuring inflation, Warsh prefers what is known as the trimmed mean or median inflation gauges. These indicators, which strip out the very highest and lowest inflation readings, tend to show lower price pressures than the gauge the Fed currently uses, which is the Personal Consumption Expenditure (PCE) price index.
In and of itself, using the trimmed mean to guide policy suggests interest rates will be lower under a Warsh Fed than they would be otherwise. At present, the trimmed mean inflation reading is – at 2.3% - more than half a percentage point lower than the Fed’s favoured gauge, the widest gap since the pandemic.
But that’s not to say investors should expect a wave of cuts once Warsh is installed as Fed chair. Warsh has also stated he wants the central bank to abandon what’s known as average inflation targeting – through which the Fed allows price pressures to temporarily move above or below its 2% target – in favour of a stricter regime.
This means the central bank will be more likely to hike rates if inflation drifts above 2%. The likely scenario at a time when energy prices are rising is that the Fed maintains higher real interest rates for longer, which will also put upward pressure on bond yields and the dollar.
The end of forward guidance
One of Warsh’s two big ideas is to do away with ‘forward guidance’ a policy that was established since the 2008 financial crisis that aims to clearly set out the future rate trajectory for investors, businesses and households alike.
In theory, this approach – embodied in the Fed’s dot plot graph – reduces the risk that financial markets are caught off guard.
Yet to Warsh, it is counterproductive, hemming in the Fed when new information suggests a change in direction. If Warsh reduces reliance on forward guidance, the range of possible policy paths between FOMC meetings widens.
This will increase uncertainty and therefore the volatility of short-term interest rates on securities with maturities of up to two years.
If communication is less regular and less clear, each economic data release and FOMC meeting will carry more information, raising the risk of sudden market moves when policy surprises occur.
Reducing the balance sheet
The second of Warsh’s big ideas concerns the Fed’s use of its balance sheet as a monetary policy tool. He believes that, at $7trn, the central bank’s holdings of government bonds are too large and has made no secret of his desire to shrink them as soon as practicable.
His lack of enthusiasm for measures such as quantitative easing suggests the Fed cannot necessarily be relied on to offer a backstop in the face of severe economic or market turbulence.
Over time, his preference for a smaller Fed balance sheet – combined with liquidity rules that encourage banks to hold more T-bills and fewer reserves – could force private investors to hold more longer-duration – and therefore riskier – fixed income securities. This could also result in structurally higher term premia, and steeper yield curves.
Adjusting diversified portfolios
Bond investors with diversified portfolios do not need to radically overhaul their allocations in response to a Warsh-led Fed. However, there are three prudent measures to consider.
The first is to reduce interest rate risk, focusing investments in lower-duration bonds instead of higher duration ones. This is because questions about central bank independence and the growing risk of fiscal dominance – or governments having sway over interest rates - are most likely to have negative effects on longer-dated bonds.
The second mitigation measure would require increasing the portfolio’s allocation to core investment grade credit, which is less sensitive to such risks.
The third step investors could take is to invest more of their fixed income assets in emerging market sovereign bonds.
While this last option involves taking more risk, a fragmenting world economy, and improvements in how many emerging economies are managed argue for a strategic upgrade of emerging markets within the overall bond mix.
That means investing in countries with solid balance sheets, orthodox central banks and deepening local markets.
Mickael Benhaim, head of fixed income investment strategy & solutions at Pictet Asset Management. The views expressed above should not be taken as investment advice.