“We think the Fed runs the risk of causing a significant tightening of financial conditions if it disappoints market expectations by remaining on hold”, BNP writes in a Wednesday note, changing their Fed call to include another rate cut at the October meeting.
In and of itself, this isn’t really notable, but as alluded to in that brief excerpt, the color the bank employs in explaining the situation is very pertinent and speaks directly to the “hall of mirrors” effect we’ve discussed here at length.
As reiterated earlier this week while documenting new analysis from Goldman quantifying the effect of Donald Trump’s tweets on Fed pricing, the reason trade threats are such an efficient tool for the US president when it comes to forcing easier monetary policy is precisely because of the outsized impact those threats have on market pricing. The more cuts the market prices in, the more dangerous it is for the Fed to disappoint those expectations, as wrong-footing the market risks bringing about an acute tightening of financial conditions.
Read more on the ‘hall of mirrors’ effect
This creates a self-fulfilling prophecy, which is precisely what BNP cites in explaining why they now expect another cut this cycle.
The bank of course mentions recent data, which includes a decade-low ISM manufacturing print and an ISM services gauge that now sits at a Trump-era nadir after disappointing expectations last week.
That gives the momentum to the doves, and they’ll have even more room to crow (sorry) if retail sales disappoint ahead of the October meeting.
But at the end of the day, the tail is wagging the dog.
“With markets currently expecting another rate cut in October, we return to the circularity argument the Fed has highlighted in recent statements, namely that not moving according to market expectations may cause a material tightening of financial conditions”, BNP says on Wednesday.
(BNP)
The bank goes on to cite the stock market. “With equity markets already nervous over the delicacy of recent US-China trade talks… the Fed may go along with market expectations”.
Ultimately, then, policy has become a slave to market pricing and, unfortunately, market pricing is now a slave to one man’s Twitter account.
(Goldman)
Goldman discussed this at length over the summer. “It starts from the observation that Fed officials now seem to put greater weight on bond market pricing in making monetary policy decisions than in the past, partly because they worry more about the consequences of disappointing market expectations for cuts and partly because some of them put a significant amount of weight on bond market signals in gauging the outlook for growth and inflation”, the bank’s Jan Hatzius wrote in July, describing the same dynamic.
“This can lead to a positive feedback loop between more dovish bond market pricing and more dovish central bank decisions”, he said.
Nothing further.
The interesting part in this circular logic inside the house of mirrors, is the ultimate unknown as to what happens to the game where people chase yields and look to things like treasuries for safe havens — thus as rates trend to zero and the arbitrage game gets sort of weird with negative rate hedging, how does this impact collateral, risk and funding future value needs? Of course that type of unknown also intersects the Treasury and Fed in terms of how they (along with market players) adjust to a new world of maturity and duration challenges. Perhaps politicizing central banks, someone wins a game to continue cutting rates to zero, but just as there was wide-spread recent confusion about IOER mechanics, who will be able to explain what is being won and why? This is a very abstract game inside a hall of mirrors that will expand into a house of mirrors built on top a house of cards and everyone playing has schizophrenia or what trump has with psychosis and dementia =- should be super fun …
From the FOMC minutes: A few participants judged that the expectations regarding the path of the federal funds rate implied by prices in financial markets were currently suggesting greater provision of accommodation at coming meetings than they saw as appropriate and that it might become necessary for the Committee to seek a better alignment of market expectations regarding the policy rate path with policymakers’ own expectations for that path.
Good luck with that.