You can wait-and-see everything

Through the fourth meeting of the Fed Chair Kevin Warsh era, bond market volatility remains a fixture, though it has subsided. This is best proxied by movements in yield curves – or simply how the market expects monetary policy to develop. At his first meeting, Warsh somewhat surprised markets with a hawkish reaffirmation that the Fed would – in no uncertain terms – achieve its two percent inflation target, flattening yield curves notably on expectations of forthcoming rate hikes.

But his resolve was called into question just six weeks later in July, when three policymakers dissented in favour of a rate hike, as he was pressed on why – if the economic and inflation data supported it – did the Fed not raise rates? A lack of a convincing argument, in our view, caused yield curves to steepen sharply on expectations that the Fed might ultimately not follow through with sufficient policy tightening.

Since then, he has waffled further, as have movements in Treasury yields and yield curves, but this week’s meeting likely raised further questions about the Fed’s resolve, especially as the incoming economic data has broadly started to again surprise to the upside.

The first chart shows a measure of economic surprises which has reaccelerated toward the best levels seen over the past three years and has had a decent track record of leading the subsequent move in Treasury yields over the following two months, and thereby perceived policy rate expectations. He was again pressed on why the Fed is still taking a wait-and-see approach, which would allow it the “accumulation of more information” as noted in its official policy statement this week, but if the economic and market signs are already suggesting the Fed needs to raise rates, it still begs the question: why wait?

Economic surprises picking up again, could mean higher rates ahead

“Interrogating reality”

As Warsh coined it this week, the Fed is “interrogating reality” at each meeting by assessing the incoming economic data. While the bulk of the incoming economic data, in our view, supports further Fed rate hikes lest inflationary pressures build further, we think the Fed is increasingly watching the market’s ongoing interrogation of “virtual reality” – or the AI trade.

While the latest GDP report, also released this week, showed strong consumer consumption and exceptionally strong business investment on the back of the AI buildout, we think recent stock market volatility centres on whether the massive investment will ultimately pay off in the form of profits.

As a result of recent weakness in the tech sector, with stocks under pressure and credit spreads in tech-related corporate bonds – or the excess yield investors demand over Treasuries for implied credit risks – widening, financial conditions have tightened in recent weeks. Financial conditions indexes attempt to broadly capture market stress from the level of interest rates, yield curves, stock market levels and valuations, currencies, etc. As the second chart shows, one such measure has tightened, but remains quite easy relative to historical norms, something Warsh conceded.

Financial conditions have tightened, but remain historically easy

Citi Financial Conditions Index

Warsh attempted to attribute this tightening to the Fed’s rate hike in September, but we think that oversimplifies matters.

Tech companies are facing higher financing costs as growing credit spreads are layered on top of rising Treasury yields, but likely not to the point that many of these firms can’t afford them. Rather, it’s increasingly a question of who is left to buy the massive amount of corporate debt that has been issued this year.

In one sign of the challenge, Meta recently opted to raise nearly US$100 billion via equity rather than debt.

There are pockets of weakness elsewhere, but we remain doubtful that one 25 basis point rate hike from the Fed will ultimately do much to slow AI-related capital spending and investment.

Who will play the role of Kevin Warsh?

Bigger picture, the reason the Fed didn’t raise rates this week essentially comes down to the fact that other key policymakers said publicly that it wouldn’t. A month ago today, New York Fed President John Williams first floated the idea that there was “no need for urgency” on further rate hikes, followed by Fed Vice Chair Philip Jefferson who flagged a wait-and-see approach, and finally by Governor Christopher Waller who noted that while more rate hikes would likely be needed, there was “some flexibility on timing.”

Those comments fly in the face of Warsh’s belief that the Fed shouldn’t provide any sort of forward guidance – or really much communication at all – but others disagree.

As a result, and with Kevin Warsh seemingly unable or unwilling to play the traditional role of Fed Chair, we think markets will now look to those key figures to play the role of Fed Chair; therefore, any intermeeting comments going forward could likely have greater market implications than future Fed meetings, in our view. The Fed’s normal communications blackout ends this Friday, with Williams currently scheduled to speak on Nov. 6.

We still think economic data will take precedence in the Fed’s decision making and that will support a rate hike at the December meeting followed by further hikes in 2027. But given that so much of everything – Treasury yield levels, inflation, economic activity, Fed rate hike expectations, financial conditions, stock market performance, the “wealth effect” of consumer spending, etc. – hinges on the AI story, neither we nor the Fed can ignore developments on that front.

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