Investors are concerned that Federal Reserve Chair Kevin Warsh's plan to reduce the number of annual rate decisions could lead to more volatility in the $32 trillion U.S. Treasury market.
Warsh announced the plan after the Fed on Wednesday declared it would keep rates unchanged. The Fed will gradually cut its annual rate decisions from eight to six, with the remaining two meetings reserved for broader strategic discussions. Next year, the number of rate decisions will first be reduced to seven. Warsh said the move is intended to give officials "time and space" for discussion.
But in the eyes of traders, the move further pushes the Fed under Warsh's leadership toward a direction where policy is harder to predict, including his abandonment of forward guidance, the practice of signaling policy actions to the market in advance. This shift could intensify market turbulence over time.
Traders say that longer gaps between rate decisions could mean the Fed sometimes needs to make larger rate cuts or hikes. The move also raises the possibility that the Fed will take emergency action between regular meetings, or lead to increased volatility in short-term U.S. Treasuries and push up the risk premium investors demand for holding long-term bonds.
"This is the clearest signal yet that the Fed under Warsh has no intention of acting as a suppressor of rate volatility, and is fully willing to add volatility through surprise announcements if circumstances require," said Isaac Wheeler, managing director of balance sheet strategy at Derivative Path.
Reducing the number of rate decisions could also reduce the Fed's opportunities to tighten monetary policy in this cycle. The market currently expects the Fed to continue raising rates to curb inflation. Traders say that overall, this puts downward pressure on short-term yields, although policy uncertainty could push long-term yields higher.
The news, combined with Warsh's dovish tone at the press conference, drove short-term U.S. Treasuries higher on Wednesday. Long-term Treasuries lagged, and the yield curve steepened. Since Wednesday, the spread between 30-year and 2-year Treasury yields has widened by about 10 basis points.
Scott DiMaggio, head of fixed income at AllianceBernstein, said that over the long term, more risk premium will be priced into the yield curve because of these volatile events.
Mechanism change
Warsh previously said that forward guidance limits the Fed's flexibility and should only be used during economic crises. Since taking office in May, Warsh has promised to bring "mechanism change" and set up a working group to study the Fed's communication strategy, including the press conference schedule and the dot plot that reflects officials' policy forecasts.
Warsh first raised the idea of reducing the number of policy decisions at the Fed's July meeting. On Wednesday, he said the change would allow policymakers to "rethink major issues."
Kerry Craig, a global market strategist at JPMorgan Asset Management in Melbourne, said Wednesday's statement "marks the beginning of a new era of 'forward silence' at the Fed, and a further change in the Fed's communication mechanism."
Traders say that measures of rate volatility over the next two years are currently little changed, partly because details of the new meeting schedule remain limited. The Fed has not yet said which meeting in 2027 will be changed to a strategic discussion meeting, only that it will be in the autumn.
Traders and economists believe the most likely candidate is the October meeting, since that meeting does not release quarterly economic forecasts. The near-term impact may also be limited, because most market participants are betting that the Fed will have finished raising rates a year from now. The overnight index swap (OIS) curve between the September and December meetings is broadly flat, meaning that if October is no longer a rate decision point, the disturbance to the market may be small.
Still, investors say that combining fewer rate decisions with less Fed forward guidance could have far-reaching long-term effects.
"Fewer rate decision meetings, plus no forward guidance, will make repricing around each meeting larger, and rate volatility will be higher than what the market is currently pricing in," said Ali Hassan, a portfolio manager at Thornburg Investment Management.
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