“Markets, however, can turn on a dime, and reactions can be outsized. This concern may be especially relevant at present, given the low level of volatility and elevated asset prices in global markets, which may increase the likelihood and severity of an adjustment.”
Governor Powell made the aforementioned statement today in a speech titled “Prospects for Emerging Market Economies in a Normalizing Global Economy.” His statement is nearly identical to observations we make almost once a week. In two days, Powell will be one of the 3 remaining members of the severely depleted Federal Reserve Board of Governors. More importantly, Powell (along with former Fed Governor Kevin Warsh) is one of the frontrunners to potentially replace Janet Yellen as Federal Reserve Chair next year. The Wall Street Journal reported today that its survey of economists places a 28% probability on Warsh’s appointment versus a 22% for Chair Yellen and 21% for Governor Powell.
If it does come down to a race between these two gentleman, one of the most interesting aspects will be that neither is a formally trained economist. Both have financial market backgrounds as Wall Street dealmakers, in addition to their experience at the Fed as members of the Board of Governors. In the early 1990s, Powell was a Treasury Undersecretary. If one of them is appointed, it would mark the first time a non-economist has led the Federal Reserve since the short lived Chairmanship of G. William Miller in 1978-1979. We expect the key difference in leadership styles between Chair Yellen and a prospective Chair with a financial markets background would be less of an inclination to micromanage every detail of the economy.
Powell is considered a moderate, while Warsh is considered the more hawkish candidate. Since Powell is currently at the Fed, his views are well known and have not strayed far from Chair Yellen. In his 5 years at the Fed, Powell has never dissented on an FOMC policy decision. Warsh left the Federal Reserve in April 2011. He gave a very candid interview with Bloomberg Television this past May.
Below are two key excerpts from that interview. He expressed surprise that quantitative easing and massive central bank balance sheets would become permanent monetary policy, not only in the United States, but around the world as well. He discussed letting the market set the price for yields at the long end of the curve. Warsh also made a call to return to “simple principles.” He was critical of the complacency at the Fed today and likened it to 2007.
Warsh concluded the interview with a statement about volatility that we believe is important - he equated it to a shock absorber. We could not agree more. We have always said a certain degree of volatility is important to keep markets honest. It forces investors to only put capital behind ideas for which they have strong conviction, which in turn promotes due diligence. Without volatility, bad actors will lever up and place capital behind sub-optimal strategies simply for the return generated by the exposure.
If weak hands are never shaken out, they simply become a larger part of the market place. We absolutely believe the day will come when the blind buyers in the equity market who are simply investing for exposure and not the conviction of the investment opportunity will turn into blind sellers.
Kevin Warsh Comments May 5, 2017 (emphasis is ours)
“I'm confused frankly about Fed's normalization strategy. You know, in the depths of the financial crisis, we can see quantitative easing. It wasn't even our best idea of how to get the economy out of the crisis. It was somewhere on the list. Little did we know that quantitative easing and this large balance sheet in paying interest on excess reserves would become almost a permanent feature of monetary policy in the U.S. and around the world.
I think once we go back to a true normalized policy, we don't need to have all these complexity. We can set a fed funds rate at the short end of the curve. And the markets will be setting what the 10- year treasury should be. Banks can then operate more flexibly on that environment. So the policies we put in place and crisis around liquidity, much of these should agree to some of my peers at Hoover. I think we're right, we were radical then, but it's 2017. Ten years ago, it was the cause for radicalism. It strikes me that we can go back to some more simple first principles.”
“Well, I will say that the Fed is very comfortable. Have you read the speeches from many of my friends who are still at the Fed? They think that the economy is perfectly benign in financial conditions, asset prices, or at perfectly fair values. I really don't know. It's not my job here at Hoover to be opining and I don't think they should have total confidence that they are so pleased with the static credit markets.
Listen, my judgment is, ultimately the Fed's biggest job is to mitigate the risks of an exponential shock. I see way too much complacency in financial markets and among most Fed speakers that the next 10 years are going to be simple and easy. This is about the same kind of uniformity of opinion I remember in about 2007.
So I'm not certain about many of the things that they are incredibly certain. And I'll just say as a last point, when I see volatility measures in the stock market in the bond market at historic lows, if I were a Central Banker, I wouldn't take comfort from that. I'd be nervous about it, because that means markets aren't positioned to be a shock absorber to a crisis, markets might amplify the crisis.”
This is a Hedgeye Guest Contributor research note written by Mike O'Rourke, Chief Market Strategist of JonesTrading, where he advises institutional investors on market developments. He publishes "The Closing Print" on a daily basis in which his primary focus is identifying short term catalysts that drive daily trading activity while addressing how they fit into the “big picture.” This piece does not necessarily reflect the opinion of Hedgeye.