Wall Street experienced a heart-stopping asset repricing on Friday. Confronted with the prospect of former Federal Reserve Governor Kevin Warsh potentially taking the helm at the Fed, investors were plunged into deep uncertainty: Is this new chair a "friend" or an "enemy" to the markets?
The market's confusion was directly reflected in dramatic price swings. On Friday, silver plummeted over 30% at one point, marking its largest single-day drop since March 1980; gold fell as much as 11%, suffering its worst day since January 1980. Concurrently, the U.S. Dollar Index surged 0.9%, the 10-year Treasury yield climbed to 4.24%, the S&P 500 index dipped a modest 0.4%, while the more liquidity-sensitive small-cap Russell 2000 index declined 1.5%.
The core catalyst for this chain reaction lies in Warsh's seemingly contradictory policy stances. On one hand, he has called for the Fed to cut interest rates more swiftly; on the other, he firmly advocates for shrinking the Fed's massive balance sheet (i.e., quantitative tightening).
Priya Misra, a Fixed Income Portfolio Manager at J.P. Morgan Asset Management, pinpointed the market's primary concern: "People are reacting to his comments that the balance sheet should be smaller. That has very big implications for risk assets."
For the market, while interest rate cuts are undoubtedly positive, if they are accompanied by aggressive balance sheet reduction, liquidity will be drained. This is the underlying logic behind Friday's market performance, which saw a simultaneous sell-off in both safe-haven assets (gold/Treasuries) and risk assets, with the U.S. dollar standing alone as the winner.
The shadow of quantitative tightening represents the foremost worry for risk assets on Wall Street.
Wall Street's greatest apprehension concerns Warsh's attitude toward the Fed's balance sheet. Warsh served as a Fed Governor from 2006 to 2011, during which he was known as an "inflation hawk." For years, he has argued that low interest rates and large-scale bond purchases fuel price increases. Although his recent comments have shifted toward supporting faster rate cuts, his steadfast commitment to shrinking the balance sheet leads some investors to believe this could dilute the stimulative effect of any easing.
Currently, the Fed has just begun expanding its balance sheet again by purchasing short-term Treasury bills to alleviate pressure in the overnight lending markets. If Warsh were to reverse this trend upon taking office, market liquidity would face a severe test.
Despite the market voting with its feet, top echelons on Wall Street are not uniformly pessimistic. Many seasoned investors believe Warsh's greatest value lies in his "independence." Compared to the "easy money standard-bearer" previously demanded by President Trump, Warsh is seen as the right person to withstand political pressure and maintain the central bank's autonomy.
Rob Arnott, Founder of Research Affiliates, stated, "Warsh is a pragmatist. He will be a voice of reason, and that will be calming and soothing for the markets." Hedge fund titan Paul Tudor Jones was even more complimentary, describing Warsh as "very market savvy." Jones believes, "In an environment where debt exceeds 100% of GDP and the deficit rate is 6%, he is the perfect person to guide us through potentially challenging times." Dan Ivascyn, Chief Investment Officer at Pimco, also sought to reassure the market, saying, "The market will be comfortable with this choice; he will demonstrate sufficient independence."
From a trader's perspective, Friday's market action also revealed a shift in another underlying logic. The previous record highs in gold and silver largely reflected a loss of confidence in the U.S. dollar and U.S. assets (the "currency debasement trade").
However, the emergence of Warsh as a candidate appears to have reversed this expectation. The dollar's strong rebound on Friday, coupled with the precious metals crash, suggests investors are retracting this "vote of no confidence." Peter Boockvar, Chief Investment Officer at OnePoint BFG Wealth Partners, summarized the uncertainty surrounding these complex sentiments with a pun:
"Will the real Kevin Warsh please stand up?"
Ultimately, all current market volatility represents a bet on the answer to the question: "Who is the real Kevin Warsh?" His policy positions are complex and difficult to decipher: a known "inflation hawk" who recently pivoted to calling for rate cuts, yet remains fixated on balance sheet reduction. This complexity renders any simple "dovish" or "hawkish" label utterly inadequate.
It is crucial to note that even if Warsh assumes the chairmanship, he cannot set policy unilaterally. While the Fed Chair wields significant influence, they remain constrained by the committee voting mechanism. Divisions are already apparent within the Fed; this week, the Federal Open Market Committee (FOMC) voted to hold rates steady, but two Trump-appointed Governors, Waller and Milan, dissented, favoring a 0.25 percentage point cut.
Some investors point out that if the U.S. were to experience frequent public disagreements between the central bank leader and the committee on rate decisions, similar to the situation in the UK, it would signal a significant change. This could potentially pressure markets by increasing uncertainty about future policy decisions.
Clearly, Wall Street requires more time to digest the complex signals emanating from this potential new chairman.
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