Fed Elevates Ambiguity to the Heart of Monetary Policy at Jackson Hole

A famous market adage says bond vigilantes are just like equity perma-bears, except for the fact that they understand math. That’s probably because, unlike perma-bears, vigilantes are famous for knowing when the risk-premia is too unfavorable for them — and just when it isn't.

For those unfamiliar with the term, ‘bond vigilantes’ was coined in the early 80s by the famous Ed Yardeni at the height of the inflation crisis. It refers to a bond trader who wields their influence by selling a significant volume of bonds. They do this to express their disapproval or dissatisfaction with the policies of the bond issuer.

Amidst Powell’s latest actions, one aspect has become strikingly clear: Powell & Co.’s number one goal in recent months has been to ensure that the bond market stays precisely where they want it to be, that is: dazed and confused.

Powell's Koby Bryant Moment

The reasoning behind the Fed’s logic is simple: it wants to prevent the market from anticipating either easing or tightening financial conditions, thus maintaining an upper hand over the bond market in terms of adapting monetary policy according to the economic data.

This situation, illustrated in part by the divergence in futures positions, grants the Federal Reserve Chair and fellow policymakers significant room for maneuver in promptly adapting their policies over the upcoming months in response to evolving economic data.

In fact, following Powell's Koby Bryant moment at the Jackson Hole Symposium last week — where the Fed President clearly stated, “Job not done” or, in his lexicon: “We have a long way to go” and reaffirmed the Federal Reserve’s commitment to the 2% inflation target —, the likelihood of a rate hike in September saw a notable increase, rising to approximately 20%, according to investing.com’s Fed Rate Monitor Tool.

Source: Investing.com

Moreover, the chances of a rate hike in November experienced a significant uptick, exceeding the 50% mark.

More than underscoring the actual probability of a rate hike, the shifting sentiment within the market shows that investors are poised to remain uncertain about the pace of the Fed’s policy until 2024 at least.

With the bond vigilantes under control due to high monetary policy risks, the Fed is likely to find more room for maneuver in the next few months.

Ambiguity as Monetary Policy

Since the beginning of this rate hike cycle, jawboning has been one of the main tools from Powel to keep markets in check. In essence, the Fed says one thing, does another, and expects investors to take care of the rest by pricing in the risks.

However, the Jackson Hole event from last Friday appears to have made clear that a new phase of this cycle is already underway: one in which ambiguity IS the core of the Fed’s monetary policy and not just another tool. Powell said in his speech:

“We are prepared to raise rates further if appropriate, and intend to hold policy at a restrictive level until we are confident that inflation is moving sustainably down toward our objective,” Powell said in his speech, suggesting at least one additional rate hike is possible in 2023.

“Given how far we have come, at coming meetings we are in a position to proceed carefully,” Powell said. “We will proceed carefully as we decide whether to tighten further or, instead, to hold the policy rate constant and await further data.

“Two months of good data are only the beginning of what it will take to build confidence that inflation is moving down sustainably toward our goal. There is substantial further ground to cover.” said Powell.

How’s that different from all the jawboning we have seen over the last few years?

Well, in the jawboning phase, Powell and Co. were actively misleading the market by constantly affirming the opposite of what they had planned on doing in the near future.

Still, despite all the comments from Powell along the way, the Fed’s rate hike agenda played out exactly in the form it had planned since the beginning of the cycle.

Since everyone knew what was going to happen, markets acted out in high accordance with the expectations of the monetary cycle -- dropped in 2022 as the policy rate was expected to get much higher and bounced back as the end of the cycle clearly approached this year.

Now, the Fed finds itself uncertain about its future course of action. However, as it has found out, it wants things to stay that way.

That’s because two intertwined opposing forces are pulling markets: the expectation of the end of the rate hike cycle and the probability of a recession in the near term.

Against this backdrop, Powell has realized he can manage forces spanning from either aforementioned factors by keeping the equity and debt markets at consistently high risk.

Therefore, by not having to set a long runaway goal for interest rates and its balance sheet, it can control market expectations much better than by simply jawboning.

This indicates that regardless of whether the Fed decides to raise rates once more, conditions will continue to be highly constricted along the entire spectrum of interest rates and within the broader economy.

This suggests that policy lags by themselves will exert additional pressure for further tightening.

Bond Vigilantes and the Fed

That’s where the bond vigilantes come into play: since they understand exactly how to price in those risks, real uncertainty is likely to keep them in check for the near future.

The fact is bond vigilantes are currently moving in tune with Powell’s cues, while the sole dependable purchasers of bonds are life and annuity funds steadily amassing assets geared towards long-term yield.

And why is that so important? Mainly because the bond market is bearish enough already, and a further selloff at the latter part of the curve would increase recession risks again.

On the other hand, Powell needs to simultaneously keep the equity market under threat of at least one or two more rate hikes, thus not allowing inflation to pop back up again.

And how he aims to do that? Well, again, by controlling the yield market all along the curve.

In fact, as of this point, ambiguity as monetary policy has worked out better than any other monetary policy from Powell — which wouldn’t be so difficult after the Covid/post-Covid fiasco.

Currently, we’re expecting a nearly 5% uptick in Q3 GDP with cash yielding 5.30%, 2-year yields at 5.10%, 10-year yields at 4.25%, and, most importantly, 30-year mortgages at 21st-century highs of 7.30%.

Of course, let’s not give Powell all the credit for this, as a very resilient labor market and a robust business environment continue to lead the economy forward against all odds.

Should American corporations and consumers fall into the much-expected contraction, Powell’s plan could blow up on the spot.

The Fed’s governor is playing a high-stakes game with the US economy. However, as of now, he is winning this round.

Bottom Line

The bond market is currently navigating a landscape where uncertainty reigns supreme. Market participants should expect volatility spanning from the all-important debt market in the upcoming months, as Powell keeps banking on the ambiguity-as-policy approach.

On the other hand, the economy could remain in balance as long as the Fed keeps vigilantes in check.

This will likely lead to a good-news-is-bad-news type of scenario, in which only the indication of a severe economic crisis would lead to any type of certainty on a change in economic policy.

However, on the positive side, if economic indicators continue to show the current positive trend in the face of high interest rates, there is a high likelihood that we may be looking toward a better-than-expected 2024.

As always, in the investment world, patience is key. But perhaps now more than ever.

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Disclosure: The author doesn't hold any of the securities mentioned.