Fed Chair Kevin Warsh Thought He Could Keep Wall Street Guessing. The Market Had Different Ideas.

The 30-year Treasury yield spent Thursday hovering just above 5.2 percent, a level the bond market hasn't seen since 2007. It got there the hard way. Up as much as 14 basis points during Wednesday's Federal Reserve press conference, then another 6 basis points after the closing bell, as traders kept selling long after Chairman Kevin Warsh had left the podium. The rest of the curve barely moved Thursday. The long end did not.

What triggered it was, on paper, a non-event.

The Federal Open Market Committee held its benchmark rate at 3.50 to 3.75 percent on Wednesday, the second straight hold of Warsh's five-month-old chairmanship. But the vote was 9 to 3 (the widest split since he took over in May), and all three dissents came from officials who wanted to raise rates, not cut them.

Nobody on the Committee is arguing for easing. The argument is about how much longer to wait.

When the Emperor Has No Clothes

"Economic activity is expanding at a solid pace despite elevated uncertainty that owes, in part, to the conflict in the Middle East," the Fed said in its statement. "Job gains have kept pace with the workforce, and the unemployment rate has changed little." Inflation, the statement noted, remains above target.

The three dissenters were Beth Hammack of the Cleveland Fed, Neel Kashkari of Minneapolis and Lorie Logan of Dallas, each pushing for a quarter-point hike. None of it should have been a total surprise.

At the June meeting, the Committee had held rates by a unanimous 12-0 vote, but the Summary of Economic Projections released alongside it told a different story: 17 of 18 officials saw inflation risk tilted to the upside.

Analysts at Icarus Asia Research, a macro research desk that tracks Fed policy for institutional clients, called that projection "the meeting's principal signal" in a note published Thursday, arguing that the hawkish tilt had been building for six weeks before it showed up as actual votes. Logan had signaled as much in a July 16 speech, saying she favored "modestly higher" rates. Kashkari's dissent was the least telegraphed of the three, the first confirmation that he had joined the hawkish camp on this question at all.

Warsh's answer to all of it was, deliberately, not much of an answer.

"There is no soft inflation target, there is no soft implicit target, not on this Committee's watch," he told reporters Wednesday. "There is only a target, and it is 2 percent." Asked about the bond market's reaction during his own remarks, he did not walk it back. He called the move "among the most significant in the last two decades, ranking around the top decile or so," and then argued that was a feature of his approach, not a flaw in it. "Market participants are learning to play the ball, not the referee," he said, "and market prices will continue to respond in the direction and magnitude they see fit."

There is no soft inflation target, there is no soft implicit target, not on this Committee's watch - Kevin Warsh

That is the whole strategy, as far as Warsh has described it.

Say less, and let the bond market do the pricing that the Fed used to do with its own language. Whether Wednesday's sell-off proves he can afford to keep doing that is now the open question on trading desks.

Jon Hilsenrath, a long-time Fed observer, put it more bluntly than most.

Warsh, he said, "didn't convey the message clearly or explicitly, and the bond market puked on him." Claudia Sahm, chief economist at New Century Advisors, LLC and a former Fed staff economist, has made a related but sharper point for weeks.

That withdrawing forward guidance is not the same thing as withdrawing an explanation of how the Fed actually reacts to data. "What is really helpful is to know, what are the contingency plans?" she said ahead of the meeting. "What would it take for the Fed to raise rates? What data are you looking at? How are you evaluated? What's your timescale?"

What is really helpful is to know, what are the contingency plans? - Claudia Sahm

Warsh has not, in two meetings, answered those questions directly.

When You Say Nothing at All

Warsh came into the job with a decade-old reputation for saying what he thinks regardless of the room.

Warsh resigned from the Fed's Board of Governors in February 2011, the only sitting governor at the time to publicly oppose the Fed's second round of quantitative easing, on the argument that it would leave markets addicted to central bank support. He studied under Milton Friedman as a Stanford undergraduate and has repeated Friedman's line that inflation is, at bottom, a choice.

Before returning to the Fed, he spent nine years managing money for Stanley Druckenmiller at Duquesne Family Office. Before that, at 35, he was the youngest Fed governor in the Board's history, sitting beside Ben Bernanke through the worst weeks of the 2008 crisis; Bernanke's own memoir names him as his most frequent partner on the crisis-era phone calls that decided which firms lived. Warsh was sworn in as the Fed's 17th chairman on May 22, beating out Kevin Hassett for the nomination after Jerome Powell's term expired.

He is not simply managing the funds rate.

He has stood up five internal task forces to rethink how the Fed operates, each stacked with outside economists: one on communications, led by former Bank of England Governor Mervyn King; one on the balance sheet, with Harvard's Karen Dynan and Jeremy Stein and the University of Chicago's Raghuram Rajan; one on data, led by Harvard's Raj Chetty, former Walmart chief executive Doug McMillon and the University of Chicago's Kevin Murphy; one on productivity and jobs, including Marc Andreessen; and one on inflation measurement, led by Thomas Sargent and Harvard's Greg Mankiw.

That last group is weighing whether the Fed should drop its traditional headline inflation gauge, the personal consumption expenditures price index, in favor of a trimmed-mean measure that strips out short-term shocks. Supporters say it would show the real inflation trend underneath energy spikes and one-off shocks. Critics, including Sahm, warn it risks masking a genuine, broad-based overshoot at exactly the moment the Committee needs to see one clearly.

Not in Anyone's Court

Thursday's economic data gave both camps something to point to.

Second-quarter growth came in at 1.5 percent, below the 1.8 percent economists surveyed by Dow Jones had expected. Core inflation, which strips out food and energy, rose 0.1 percent for the month and 3.3 percent from a year earlier; the monthly figure missed the 0.2 percent forecast, while the annual rate matched it. Growth is cooling. Inflation, at 3.3 percent, is still well above the Fed's 2 percent target and showing no clean sign of breaking lower.

Deutsche Bank's economists, who expect the Fed to still deliver 50 basis points of increases this year (a quarter point in September and another in December), argued the central bank is unlikely to read Wednesday's bond reaction as any kind of endorsement. The combination of rising long-end yields and falling forward real yields, they wrote, points to market doubt that inflation is actually headed back to target, not confidence that it is. They added that broader credit conditions still look supportive, but a steeper yield curve could squeeze a housing market that is already weak.

They added that broader credit conditions still look supportive, but a steeper yield curve could squeeze a housing market that is already weak. - Deutsche Bank

Sitting underneath all of it is a newer question Warsh has raised himself and not resolved.

Whether the roughly 20 percent annual growth in high-tech equipment and software investment, driven largely by the artificial intelligence buildout, is starting to show up as real inflationary pressure or whether it's a narrow, visible shock that the Committee shouldn't read too much into.

Chip and data-center spending is easy to see and easy to blame. Whether it's actually moving the inflation numbers that matter is a separate question, and Warsh said Wednesday that the Committee has not settled it.

Trading desks, for now, have a simpler problem than any of that.

Heading into Wednesday's meeting, open interest in fed funds futures had reportedly climbed above 900,000 contracts, a record, with pricing that implied roughly a one-in-three chance of a hike and almost no chance of a cut.

The Fed delivered the outcome the market expected. What it didn't price in was the size of the dissent.

Three sitting regional presidents are now on the record wanting to raise rates immediately, at a meeting where inflation was still running at 3.3 percent and growth had just come in soft.

Icarus Asia's Rates Strategy Team wrote Thursday that it is now watching the dissent count itself, not anticipated Fed language, as the more reliable signal of where policy goes next.

Warsh has made it clear he isn't planning to make that job any easier.

The author is the Head of Research and Analysis at Icarus Asia, an independent strategic advisory and research firm headquartered in Hong Kong. It specializes in in-depth analysis of Asian financial markets, macroeconomics, and high-risk geopolitical dynamics affecting global investments.

DISCLAIMER: Strictly not investment advice. Please do your own research and consult with a registered financial advisor.

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