Hall Of Mirrors And The Lost Art Of Controlled Burns

“In my experience this affliction is one the Federal Reserve guards against and does not suffer from”, Richard Clarida said, in remarks delivered Friday at a panel discussion in New York.

He was referring to the “hall of mirrors” effect, whereby the Fed ends up cornered by market expectations, something Ben Bernanke warned about in 2014. Donald Trump has – wittingly or not – figured out how to leverage this dynamic to compel rate cuts.

“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”, Goldman’s Jan Hatzius wrote last year, adding that “this can lead to a positive feedback loop between more dovish bond market pricing and more dovish central bank decisions”.

What Trump figured out in May, is that he needn’t go full-Erdogan (as it were) to commandeer US monetary policy. Rather, all he had to do was engineer enough uncertainty to compel the bond market to start aggressively pricing in cuts. Once those expectations were in the market, the Fed was effectively backed into a corner: Disappointing those expectations (a de facto declaration of independence from the Oval Office’s political whims) risked wrong-footing the market and bringing about an unwanted tightening in financial conditions, which could very well end up necessitating rate cuts anyway.

It’s a highly undesirable situation in which to find oneself as a policymaker, but there is little question that the “hall of mirrors” effect was in play at various intervals in 2019.

We’re on the verge of seeing it play out again in 2020, although this time, not because Trump is deliberately engineering uncertainty (well, he is, but no more so than normal, and not with the explicit aim of influencing monetary policy), but rather because the market has seemingly realized two things:

1. If the coronavirus ends up exacerbating the economic divide between the US and the rest of the world, the dollar will continue to strengthen and the US will import disinflation, further imperiling the Fed’s efforts to avoid the kind of Japanification which has now set in across Europe.
2. The US economy isn’t going to escape unscathed from the burgeoning pandemic

In other words, Clarida’s contention that the “hall of mirrors” effect isn’t an “affliction” the Fed suffers from is probably going to be put to the test in relatively short order. In fact, the market is now pricing nearly two full cuts by year-end, and the 2s10s is closing in on 10bps.

Meanwhile, over the last two days, tech shares have underperformed the broader market by a cumulative 1.8%. The S&P logged its first weekly loss since January.

Hilariously, this was the first week since early December that the S&P managed to outperform the Nasdaq 100.

Gold shined, surging nearly 4% in the best week since China let the yuan slide through 7.00 in early August. Goldman sees a rally to $1,850 assuming the virus effects last into the second quarter.

Speaking of the yuan, it’s sitting at the weakest since early December, as PBoC easing, weaker fixes and doubts about the Chinese economy’s capacity to absorb the blow from the virus weigh.

The big story on Friday was, of course, the rather shocking miss on Markit PMIs, which suggested the US economy will not be immune from the coronavirus. 30-year yields fell to the lowest on record at 1.884%. Market participants remain reluctant to carry risk into the weekend, wary of the next headlines around the mini-pandemic.

“The primary themes at play in global financial markets remain well intact”, BMO’s Ian Lyngen, Ben Jeffery, and Jon Hill write, enumerating those themes as follows:

1. coronavirus jitters dominate the macro narrative,
2. flight-to-quality flows persist despite record high equities,
3. the Fed’s commitment to keep rates on hold barring a ‘material reassessment’ has flattened the yield curve to local extremes, and
4. the Democratic nomination is still anyone’s guess at this stage

As far as whether this week was the beginning of a deeper swoon for stocks which, just 72 hours ago, were sitting comfortably at new records, the answer is the same as it ever was: “Who knows”.

What we do know, however, is that Clarida is being at least a bit disingenuous to suggest that the Fed doesn’t succumb to the “hall of mirrors” effect. If the curve keeps flattening and the market keeps pricing in cuts, they’ll either need to pacify those expectations and try to re-steepen the curve, or face the consequences. And not just from markets, but from Trump’s irate Twitter feed headed into the election.

The January FOMC minutes contained a reference to using monetary policy to short-circuit potential bubbles (the committee calls them “financial stability risks”) in the absence of effective macroprudential tools.

JonesTrading’s Mike O’Rourke wasn’t amused. “This was potentially some staged sort of jawboning to insert a dose of reality in markets, but if this market is ignoring [revenue warnings] from the largest, most followed companies in the world, it certainly is not taking a cautious signal from the FOMC minutes”, he remarked, referencing Apple’s cautious guidance.

“It’s probably too late for Chairman Powell and the Fed to avoid being the owners of this speculative frenzy when it bursts”, O’Rourke went on to lament, adding that the “vague communication” from the minutes doesn’t help.

What the Fed needs to do, O’Rourke advised, is “start studying up on controlled burns and firebreaks”.