This Is What ‘Max Central Bank Predictability’ Looks Like

Last weekend, on the way to explaining what incoming Fed Chair Jerome Powell meant five years ago when he discussed the Fed’s “short volatility position” at the October 23-24, 2012 meeting, we said the following about how the central bank’s communication strategy dampens vol. across the board (i.e. beyond the obvious way in which rates vol. is suppressed by the Fed effectively absorbing prepayment risk and obviating the need for MBS investors to hedge):

That’s not to say that the Fed’s communication strategy vis-a-vis markets hasn’t served to tamp down equity market vol. It obviously has.

The story with the VIX and thereby SPX, is the same as it’s ever been. The two-way communication loop between policymakers and markets which effectively allows the market to have a “say” in the evolution of the policy narrative clearly dampens vol. across the board.

Again, that’s to be distinguished from the very specific mechanism whereby the Fed’s MBS portfolio keeps a lid on rates vol. (of course distinguishing the two doesn’t mean one doesn’t compliment the other).

The excerpted passages there harken back to Aleksandar Kocic’s “fourth wall” analogy, which made its debut in a Deutsche Bank noted from September of 2015. Here are some excerpts from Kocic’s September 2017 note, which explained what the implications might be of a Kevin Warsh Fed (this was back when Warsh’s name was still being tossed about):

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 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.

To illustrate that, all you have to do is look at the evolution of market pricing headed into Fed meetings and on Wednesday, BofAML is out with a piece that underscores everything Kocic has been talking about for years.

First, the bank reminds you that the risk of an inflation surprise that forces central banks to turn aggressively hawkish in their communication with the market (i.e. to effectively cancel the market’s license to co-author the script) is the biggest risk in 2018:

Rising inflation is among the top worries for IG investors in 2018. Also, credit investors think the most underappreciated risk in 2018 is a “substantial rise of inflation”. That would undoubtedly push vol higher, and central banks would be seen as having been behind the curve. However, we have highlighted that central banks cannot afford to introduce too much volatility too fast, and for that reason we think they will remain predictable — thus continuing to “sell vol” for another year.

Right. And see that’s exactly what we highlighted last weekend in the Powell piece. That’s one way central banks are “selling vol.” outside of the narrow context inherent in Powell’s 2012 comments. BofAML continues with what amounts to a reiteration of the “fourth wall” analogy:

Over the past few years, we have seen max central bank predictability. The best example to illustrate comes from [the U.S.]: the Fed raised rates only when the market had already priced them in. Or put another way, the Fed’s communication heading into rate decision day smoothly guided markets to price in the eventual rate decision.

We think the ultimate goal has always been to not introduce too much uncertainty on the rates policy. The chart below shows that over the past nine rates decisions, the Fed has always delivered what was expected (hike, or unchanged rates policy). For the coming March meeting, the expectation of a hike is slowly getting priced in.

Needless to say, breaking with this precedent of predictability – i.e. becoming less transparent – carries enormous risks.