Central banks may be reinstating the fourth wall.
Following Janet Yellen’s decision to postpone liftoff at the September 2015 FOMC meeting amid market upheaval triggered by China’s overnight devaluation of the yuan the previous month, Deutsche Bank’s Aleksandar Kocic described a sea change in monetary policy.
“The Fed decision showed that when everything fails, common sense remains the best guide. And common sense prevailed,” he wrote, adding that,
This changes everything. Power relations have been revealed; nothing will ever be the same. In that sense, despite seeming status quo, the FOMC was a true Event in the sense of being an encounter which retroactively creates its own causes.
What we now have is another data point which outlines the contours of the Fed reaction function. Fed’s communication strategy, it is becoming clear, is an equivalent of what in theater context is referred to as Removing the fourth wall whereby the actors address the audience to disrupt the stage illusion – they can no longer have the illusion of being unseen. An unalterable spectator becomes an alterable observer who is able to alter. The eyes are no longer on the finish, but on the course – what audience is watching is not necessarily an inevitable self-contained narrative. The market is now observing itself from another angle as an observer of the observer of the observers.
The audience (markets) was, from then on, no longer a passive observer of a monetary policy play unfolding on stage. The audience instead became part of the play, which by virtue of the two-way communication channel, was no longer on a preset course. The reflexive nature of the relationship between the Fed and markets created a series of self-feeding dynamics that optimized around themselves, culminating in a vol-seller’s paradise.
Later, in a separate note, Kocic wrote that, “There is an implicit symbolic pact between central banks and the markets: The Fed knows that the market knows and the market knows that the Fed knows that the market knows, so everyone knows, but pretends that nobody knows and the game goes on.”
Markets were consulted by policymakers, and thus become a part of an ongoing drama that, by virtue of their participation, could have no resolution. It was a kind of rolling plebiscite without any fixed goal posts. Or, as Kocic put it years ago, there was an absence of “rigid reference point[s], like a well specified reaction function, objectives, and triggers.”
Now, inflation appears to be making a comeback as a “rigid reference point,” prompting policymakers to rebuild the fourth wall by rediscovering their reaction function (i.e., their price stability mandates). This is supremely ironic given that it wasn’t so long ago when policy centered around not just tolerating inflation overshoots, but actively encouraging them.
Over the past eight sessions, we’ve seen dramatic instances of the front-end repricing central banks on the notion that policymakers will not, in fact, be willing to relinquish their inflation-fighting credibility in the interest of facilitating a complete and total recovery from the pandemic. Or fostering an inclusive labor market. Or whatever else was at the top of the agenda a scant six months ago.
Last week it was the UK and New Zealand. On Wednesday it was Australia first and then Canada. The BoC’s hawkish surprise triggered what TD’s chief Canada strategist and senior Canada rates analyst called “a flash-like crash in the front-end.” “We underestimated the liquidity impact and blow-out risk around a hawkish response,” the bank said, calling the market reaction “wild.”
In addition to a huge spike in two-year yields, note that the front-end of the Cdn curve delivered a 15-sigma (!) move on Wednesday. The Dec21 BA contract sold off by 30bps after 12 months of sub-2bp per day delivered moves.
Given the distinct potential for an unwind of crowded positioning at the long-end and now frequent front-end chaos, it’s not difficult to conjure a scenario where aggressive rate hike pricing combined with a flattening curve creates a policy mistake optic with a growth scare kicker. If central banks do what the BoC did Wednesday, effectively revoking the market’s license to co-author the script, it could manifest in significant volatility.
In 2017, when Kevin Warsh was being considered for Fed Chair, Deutsche’s Kocic wrote that “the numbers that go into [policy] rules have become ambiguous and the 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.” He continued as follows:
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 [may] want 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 [could] 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. If taken at face value [some of] Warsh’s comments, are along the lines of resetting the clock and ignoring the existing distribution of risks. 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.
That was in 2017. Although things have changed quite a bit since then, you could pretty easily argue that those passages are even more applicable now than they were then.
Central banks would probably do well to consider the inherent peril in abruptly reclaiming the right to interpret the data as they see fit, without consulting the market. Policymakers have almost uniformly stuck to the “transitory” script, letting the market express its own doubts about that characterization through relatively aggressive rate hike pricing. But the manic front-end moves witnessed across locales over the past two weeks pretty clearly suggest the market isn’t actually prepared for a scenario where policy is no longer the product of a real-time information exchange with markets, but rather a choice that’s made by technocrats, without markets’ consent, and simply delivered matter-of-factly in a policy statement.