Thursday, October 4, 2018

r-star is out and bond trading is in!

There have been three important Fed guidance speeches in the last few weeks.  Investor should take note. As stated by Ian Fleming, “Once is happenstance. Twice is coincidence. Three times is enemy action”. There may not be a direct link with the current bond decline, but investors should expect more volatility and higher trading volume because r-star is out and a data dependent Fed is in. A data dependent Fed means bond trading is back.

NYFRB President John Williams stated in a speech last week that r-star is no longer relevant for policy guidance. r-star is the equilibrium or "neutral" rate of interest that should exist when there is full employment and the accepted rate of inflation. Williams, a key researcher on this topic, had staked his career on r-star as an important indicator of forward guidance. Now that we are close to r-star, he all but used  the New York phrase, "fuhgeddaboudit". It is of no use. 

From this speech, 'Normal' Monetary Policy in Words and Deeds, Williams make it clear that r-star is too uncertain to be a guide. "But, as we have gotten closer to the range of estimates of neutral, what appeared to be a bright point of light is really a fuzzy blur, reflecting the inherent uncertainty in measuring r-star." What provided a guide before is not a guide now. This turn-around in views has occurred in a matter of months.  

There is no doubt that when rates were at the zero bound everyone would agree that r-star was higher and the Fed would be raising rates to some neutral level. The direction of rates over the longer-run was clear. Now that the economy is closer to r-star or we have less certainty on r-star, its value is diminished. It may prove to be restrictive, and needs to be thrown out. There is clear that r-star uncertainty increases as we get closer to its true value, but now we may look like fools to have placed value on the Fed's r-star musings because now that rates are close to r-star, we are told it is irrelevant. It was relevant before because the Fed wanted it to be relevant. Now, things have changed.

This is consistent with the speech by Chairman Powell at Jackson Hole that the Fed is facing more uncertainty on what is the neutral rate. In his speech, Powell states "One general finding is that no single, simple approach to monetary policy is likely to be appropriate across a broad range of plausible scenarios."In fact, his speech was a signal for the more direct operational comments from FRBNY Williams. 

The speech by Governor Lael Brainard to the Detroit Economic Club on September 12th defines and defends the concept of the neutral rate but then concludes that uncertainty in its  measurement makes it risky to use and a gradual approach is better. "Beyond the near term, how much the neutral rate is likely to rise and whether it flattens or moderates further out will depend on a variety of developments--such as whether fiscal stimulus is extended or expires, whether foreign and trade risks grow or recede, and whether financial system vulnerabilities extend. As such, the gradual pace of rate increases implicit in the SEP’s median policy path incorporates a degree of caution, which is appropriate, in my view." 

Chuck that old forward guidance, the Fed does not want you to know what it is trying to do before it does it, nor does it want to be bound by star thinking. In the old world, it did not matter what any piece of information told us, it was the sum of the data in a forecast that would be the important variable. The new forward guidance is that the Fed will not give any guidance at least with reference to an economic star. The focus will be on current situations and data.

A cynic could say that the Fed guidance has been pretty poor to begin with, so let’s call an end to this forecast charade. Don’t tell investors anything about guidance because you may do more harm than good. If you look at the dot-plots, there is a disconnect between what the Fed wants, what it expects and what it gets from the market. 

The Fed is giving clear guidance of what it will not be following in the future. What this tells us is that fixed income trading based on macro data is back in vogue. Look at inflation. Follow the employment numbers. Discuss PMI. The Fed will be watching this stuff, and it will not be using any stars to help navigate, so you also better watch the data. You want to position on the data, because the next piece of information may be the one that drives policy. 

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