The Fed says nothing, and the market won’t listen

Good morning. To analyse Fed communications is to enter a wilderness of mirrors (to borrow James Angleton’s unforgettable phrase). What the US central bank says matters in large part because everyone believes that everyone else believes Fed policy is very important. The whole psychological construct threatens to disappear up its own backside at any moment. Still, we try to sort out the latest development below. Email us: robert.armstrong@ft.com and ethan.wu@ft.com.

The Fed is not hawkish. What if that changes?

Last week’s Fed meeting sent bond yields up and stocks down. The near-universal reaction was that Fed chair Jay Powell’s press conference was more hawkish than expected, confirming the central bank was behind the inflation curve and means to get ahead of it. The market now thinks four to five rate increases are coming this year.

Financial conditions were tightening even before the meeting, as this chart shows (axes are arranged so that down means tighter and up means looser):

Unhedged was a little sceptical, though:

We think the market is reading tea leaves that haven’t been brewed yet. In his briefing, Powell emphasised again and again that the Fed would be “nimble”, adapting policy to fit the economy

We have received a small measure of vindication. It seems Fed officials are trying to coax markets out of their alarm. Here’s Bloomberg yesterday:

There are signs that some Federal Reserve policymakers think that markets may be getting ahead of themselves with the projected pace of rate hikes. Four officials spoke [on Monday], each emphasising the need for gradual tightening and the need for moves to be data-dependent. Kansas City Fed president Esther George, a policy voter this year, said “unexpected adjustments” are in nobody’s interest while San Francisco Fed chief Mary Daly emphasised the need not to be disruptive.

The message, while multi-vocal, is not perfectly harmonious. James Bullard, president of the St Louis branch, said yesterday that he was in favour of increases at the next three meetings (March, May and June) and that five rises were “not too bad a bet”. But he batted away the notion of a 50 basis point March rise and echoed Powell’s mantra of data dependence. The overall message — that Mr Market needs to relax — is pretty clear.

The Fed refused to say what its new plan was, because it does not yet have one. The market’s collective imagination ran wild with the hawkish possibilities this left open. That forced the Fed to say, guys, really, we’re waiting for more data. The whole episode shows how carefully the Fed must calibrate its communications — and how extreme the market reaction might be if the Fed actually did communicate the intention to tighten more quickly.

At Unhedged, we don’t know what it will take to bring inflation down. Maybe radical action will be needed, or maybe the problem will fix itself. We’re too dumb to know. But suppose the hawks are right. One of the smartest, JPMorgan’s Bob Michele, thinks markets don’t yet appreciate just how far behind the curve the Fed is:

You look today, right at this minute. They’re still buying bonds, they’re still at zero interest rates . . . It’s just not realistic to say [that] if they do four rate hikes a year from now, the fed funds rate is at 1 per cent and that’s going to create a headwind to growth and inflation …

With all the fiscal impulse we’re seeing, with the potential for a co-ordinated global reopening, and [with] where inflation is today, 3 per cent looks realistic to me.

If the Fed ultimately gets to three per cent, that will rough up bonds badly, and stocks might well struggle too. Of course, others (our respected friends Martin Sandbu or Adam Tooze, for example) think the Fed will not be forced to move quickly. Would that imply upside for bond or stock markets from here? Not necessarily. Policy can’t get much looser than it is now (unless something else awful happens to the economy). At the risk of stating the obvious, the risks from rate policy seem heavily tilted to the downside. (Wu & Armstrong)

The crypto-equities link has got the IMF worried

Yesterday we told you about the IMF finding growing links between crypto and stocks. Today we dig into the IMFs research, produced by economist (and former pro tennis player) Tara Iyer.

Her key table compares, before and after Covid-19, how much volatility sloshed between crypto and equities (BTC is bitcoin; TTH is the stablecoin tether; RUS is the Russell 2000):

Look at the first line. It means that, post-Covid, bitcoin price volatility explained 16 percentage points more of S&P 500 volatility than before the pandemic. The overall move was from 1 per cent to 17 per cent. “Explained” here is a slippery word. What it means, roughly, is that Iyer looked at various possible explanatory factors — such as oil prices, bond yields and other stock markets — and the movement in bitcoin was the only one that could account for that 17 per cent of the S&P 500’s volatility.

Stocks and crypto moving together is not shocking, as both reflect general risk sentiment. But Iyer thinks crypto vol might cause stock vol, and vice versa:

This could be attributed to several factors, including the increasing adoption of crypto assets alongside traditional assets such as stocks and bonds in retail and institutional investor portfolios in an environment of easy financial conditions since the onset of the Covid-19 pandemic, as well as the growing acceptance of crypto assets for payment purposes.

These conclusions look striking, but should be interpreted cautiously, as Iyer emphasises. The existence and direction of causality is hard to establish. Josh Goodbody, COO of crypto firm Qredo, is sceptical:

The idea that a crypto sell-off could lead to some kind of other sell-off in equities just doesn’t make sense. It’s a bit like chicken and egg — what comes first?

Still, there are more and more links between the worlds of equities and crypto — bitcoin futures ETFs, MicroStrategy stock, crypto mining stocks, tokenised Tesla, and on and on.

Whatever the impact of crypto on stocks, it will be felt first in emerging markets with fragile financial systems. And this has the IMF worried. From a recent blog post:

The stronger association between crypto and equities is also apparent in emerging market economies, several of which have led the way in cryptoasset adoption. For example, correlation between returns on the MSCI emerging markets index and bitcoin was 0.34 in 2020-21, a 17-fold increase from the preceding years . ..

Our analysis suggests that crypto assets are no longer on the fringe of the financial system. Given their relatively high volatility and valuations, their increased co-movement could soon pose risks to financial stability especially in countries with widespread crypto adoption. It is thus time to adopt a comprehensive, co-ordinated global regulatory framework.

The FT’s Chris Flood, who interviewed the IMF director, told us that in the IMF’s view:

The threat to emerging markets has been under-appreciated by the national authorities. They think El Salvador is making an absolutely catastrophic mistake. And if the IMF is right, it means they’ll be required to ride to the rescue.

Our favourite monetary historian, Brendan Greeley, noted that the fund’s worries about crypto are similar to its fears about the hot money that can leave chaos in its wake when it flees emerging markets:

I think [the IMF] is right, but if we want to crack down on hot money flows, perhaps the right time to do that was 30 years ago in Bermuda and the Channel Islands. If we’re really worried about the wealthy moving their money too quickly out of a cold economy, there’s a lot we could crack down on. I’m sure crypto is a big part of the problem, but it’s only one part of a bigger, older problem.

It is often said that crypto is reliving financial history at warp speed. The crypto-equities link is a good example. (Ethan Wu)

One good read

If today’s letter has not exhausted your appetite for reading about the Fed, Martin Wolf makes a thundering case that the US central bank is far behind the curve: “the Fed continues to ladle out the punch, even though the party is turning into an orgy”.