According to executives at Pacific Investment Management Company (Pimco), bond investors will be closely watching next week's Federal Reserve meeting to gauge how quickly new Chair Kevin Warsh will begin to put his own stamp on the central bank.
Richard Clarida, Pimco's global economic advisor and a former Fed vice chair, noted that investors are still trying to determine how Warsh will handle the Fed's communication with the market.
"Looking back to the 80s, understandably, when a new Fed chair comes in, there is a period, perhaps measured in weeks or months, where you try to understand the institutional framework and the communication," Clarida said Thursday at a Pimco media event in New York. "For me, the real question is to what extent and how Warsh will put his own stamp and his own emphasis on that communication."
The new Fed Chair, who lobbied for the role to succeed Jerome Powell, has advocated for a return to a less transparent approach to monetary policy. During his Senate confirmation hearing in April, Warsh stated, "Unlike many of my colleagues past and present, I do not believe in forward guidance."
Bond investors are weighing potential changes, including a shorter Federal Open Market Committee statement, the elimination of the dot plot, and fewer press conferences by the Fed chair. However, if the central bank provides less guidance, making its actions less predictable, and sparks more internal debate leading to more frequent dissents from officials, investors will face a more volatile market.
"On the margin, less communication could create a bit more volatility and uncertainty, which could potentially bring more returns through active management," said Daniel Ivascyn, Pimco's Chief Investment Officer. "The Fed under Warsh will maintain sufficient independence in the areas the market cares most about, primarily interest rate and balance sheet policy."
The short-term interest rate dot plot was introduced in 2012 by former Fed Chair Ben Bernanke to help guide investors during the era of ultra-low rates following the financial crisis.
Ivascyn noted that forward guidance was "quite important" when the federal funds rate was at low levels. "So today, with the funds rate where it is, from a market perspective, it's less important." "We talk about these dots a lot, it's fun to talk about, but you have to largely ignore them, first they are individual views, there is uncertainty, and things are always happening."
Ivascyn highlighted how the bond market quickly shifted from pricing in rate cuts to expecting hikes after the outbreak of war in the Middle East. He said, "It didn't take a Fed utterance, it didn't take any official change in language, to get a selloff in the 2-year Treasury," with the yield rising from about 3.4% in February toward 4.20%.
Ivascyn warned that trying to push down short-term rates during a period of high uncertainty for the global economy and inflation could backfire for the Fed.
"Lowering short-term rates now doesn't necessarily mean that the very important 5-year or 10-year rates move in the same direction, and people recognize that," he said. "If the Fed cuts rates during this uncertain period, you're likely to see rates further out the yield curve move in the opposite direction, which we think would be counterproductive."
Ivascyn stated that Pimco will watch how the Fed under Warsh might seek to reduce the size of the central bank's balance sheet. The balance sheet, currently around $6.7 trillion, is down from a peak of $9 trillion in 2022. Warsh has previously linked shrinking the balance sheet to the possibility of rate cuts.
Ivascyn added, "The balance sheet piece is something we are quite focused on, it could have an impact on the shape of the yield curve and the performance of bonds of different maturities." "It's more important than what they do on the communication side or the parts related to forward guidance."
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