Earlier this week, in a piece for DealBreaker, I suggested that if we can take Kevin Warsh at his word when it comes to his explicitly stated desire to break the reflexive relationship between markets and the Fed, his nomination would set the stage for a rebuilding of the “fourth wall” (get it? “set the stage”, “fourth wall”, etc.)
Regular readers will immediately recognize that as a reference to the Street’s best strategist, Aleksandar Kocic, who described the Fed’s explicit acknowledgement of the reflexive relationship between policymakers and markets in the theatrical context back in 2015.
Here are some excerpts from the DealBreaker post mentioned above that should serve as a helpful (and concise) recap:
Anyway, Warsh seems like he wants to break the communication loop between the Fed and markets. That communication loop has always been implicit, but as Deutsche Bank’s Aleksandar Kocic wrote in a 2015 note, the reflexive relationship has now become explicit.
Kocic describes this in the theatrical context as “the removal of the fourth wall.” The audience (markets) is no longer a passive observer of a monetary policy play unfolding on the stage. The audience is now a part of the play, which by virtue of the two-way communication channel, is no longer a self-contained story with a preset course. As Kocic put it, “what you’re watching is not necessarily an inevitable self-contained narrative but rather, you are observing yourself from another angle as an observer of the observer of the observers.”
What the hell does all of that mean? Well, it means that the Fed is beholden to markets perhaps more than the market is beholden to the Fed and if Warsh is to be believed, he’d like to break that relationship.
Needless to say, rebuilding that wall carries considerable (call it “bigly”) risk. So much risk, in fact, that it’s almost an unthinkable proposition if it were to be done immediately and without warning. If you’re the Fed and what you want to do is break the reflexive relationship with investors and traders, it makes no sense to telegraph your intention (i.e. it would appear that it would have to be a “without warning” type of affair almost by definition). After all, the whole point in that scenario would be to stop the telegraphing.
Of course the more entrenched the communication loop between policymakers and markets becomes, the harder it is for market participants to form a long-term view. That was the premise of Kocic’s Friday note on the inherent dangers of transparency (more here). Transparency introduces risk in a paradoxical way. As Kocic wrote last week, “transparency as a way of stabilizing the markets has become a tool of suboptimal control, one that reinforces the future risk in order to diffuse it – it is a tactics of delaying, rather than reducing risk.”
The implication there is that risks pile up along the way as the “bad behavior” created by the communication loop becomes entrenched and self-feeding.
Well on Wednesday, Kocic is out discussing exactly what it would mean for the “fourth wall” if Warsh were to get the nod. He begins by confirming precisely what I suggested in the DealBreaker post: namely that if we can take Warsh at his word, the fourth wall will be rebuilt.
But Kocic goes further, noting that “giving up transparency and sticking unconditionally to policy rules, i.e. rebuilding the fourth wall, carries with it enormous risks.”
His new note, making the rounds to clients this morning, can be found below. What it doesn’t say, but what seems at least implicit even if Kocic wouldn’t himself phrase it as such, is that if Warsh gets in and deliberately stays behind the curve on rates to appease Trump while simultaneously moving aggressively to unwind the balance sheet just as Trump goes ahead with deficit spending, it would be all over, folks. A total sh*t show: equities, credit, rates, dollar, all of it. It all sells off. On the “bright” side, volatility would return – and “big league.”
Via Deutsche Bank
Kevin Warsh is perceived as a frontrunner for the new Fed chairman position. He has been a staunch critic of the current Fed in the context of their exit strategy. In his view “Changes in judgment should be encouraged, but they ought to indicate something other than day trading or academic fashion. They must be rooted in strategy.” Otherwise — it is his opinion — we will be worse off as the effects of such shortsightedness accumulate.
Stimulus unwind has been designed along the lines of what in theatrical context is known as removal of the fourth wall: The audience (market) is no longer a passive spectator, but becomes actively involved in shaping the script. In that setup the Fed is effectively long an option to hike (or not to hike): depending on the market conditions and assessment of market’s reaction Fed can expand their reaction function and mandate in such a way to keep smooth operation of the markets. At the same time, Fed is short a “credibility” option by running a risk of upsetting the markets and/or creating a perception of eroding confidence. This “credibility” short has been the major source of volatility supply to the markets.
Warsh has criticized Fed’s transparency and has minced no words when it comes to highlighting the downside of the Fed’s position (“When central bank acts in response to a monthly payroll report, it confuses the immediate with the important”). In their efforts to fine tune the economy, Fed’s usage of transparency has effectively shrunk horizons and subordinated any long-term objectives to the short-term gains of the market and in that process they continue to encourage and reward bad behavior. Warsh has been wholeheartedly for rebuilding the fourth wall between the markets and the Fed. According to him, the Fed should adhere strictly to clearly defined policy rules and long-term objectives without having to consult the market about its willingness to accept them.
He is talking about the same rules the current Fed is using. However, when it comes to divergence between his and Fed’s views, the problem is that the numbers that go into these rules have become ambiguous and circularity of the Fed/market interaction that comes with the removal of the fourth wall — the dynamics that involve the market as a co-writer of the script — insures a one-dimensional interpretation of these ambiguities. Under market’s pressure the Fed’s interpretation of the ambiguity of the economic numbers which enter the policy rules has taken a predictable path of least resistance after the markets are consulted. Warsh wants to withdraw that ambiguity of interpretation from the dialogue and make it the Fed’s discretionary right. Unlike the Fed which has been using these rules conditionally (subject to markets’ approval), he wants to switch back to their unconditional usage. In itself, this is effectively a withdrawal of convexity from the market.
However, giving up transparency and sticking unconditionally to policy rules, i.e. rebuilding the fourth wall, carries with it enormous risks. Eight years of stimulus has created substantial tail risk. Warsh’s comments, if taken at face value (even without taking into account his political affiliations), are along the lines of resetting the clock and ignoring the existing distribution of risks. Such rhetoric, when taken as agenda and converted into actions, implies what from a current perspective can only be characterized as reckless. How does one reinstate the fourth wall against the minefield of tail risk? And how does one diffuse the tail risk if everything you do makes things worse? It is not difficult to imagine how risk assets, especially equities and credit which have enjoyed extremely favorable positive externalities, would react to such a change.
Warsh’s nomination would mean effectively withdrawal of convexity (Fed put) from the market and would raise the stakes by downplaying the risks associated with disorderly policy unwind. Both of these would create a definitive support for volatility across the board. If combined with deficit spending (bear stepeners!), volatility would return with vengeance.