Warsh needs to restore his reputation

Outlook

We were glad to see our deeply negative reaction to the Warsh press conference was not some personal peculiarity.Just about everybody in the financial press felt the same way. The consensus is building it’s not the Fed in the dog-house but only Warsh.

Today the WSJ changedittune and blasted Warsh—”the honeymoon is already over..” It reports “The bond market has a message forKevin Warsh: Don’t try that again.

“Yields on longer-term U.S. Treasurys held near their highest levels in 19 years Thursday, a day after theFederal Reservechairmanjolted the marketby failing to persuade investors that he was willing to support rate increases to fightinflation.

“The moves were unusual—and alarming. Even as yields on longer-term bonds surged, those on short-term Treasurys fell, indicating concerns that the Fed would wait too long to lift rates and then have to raise them aggressively down the road.

“For the new Fed chairman, the action amounted toa warning shot. As yields stabilized Thursday, many investors and analysts said they ultimately still thought that the Fed would respond appropriately to economic data. But they also said that, if given more reason to doubt the central bank, the next selloff would be worse—triggering a damaging increase in rates on everything from mortgages to corporate debt.”

The message is crystal-clear:the Fed must now deliver the Sept rate hike or the Fed gets contaminated, too. We guess the next consumer expectations surveys will not reflect the response, because regular people don’t know or care about who is the Fed chief. It’s the financial market players who care, and they have spoken.

Warsh needs to restore his reputation. To persist in declaring inflation the top goal is not enough. The market wants action, not words. It also wants some respect. One of Warsh’s big mistakes was to say it needs to “re-learn how to price risk.” When the institutional factor, aka the Fed, raises risk by refusing to disclose its view or making confusing and conflicting statements, higher risk means higher rates.

Nobody know how long this semi-crisis will last because the outcome depends on a single guy who has been backed into a corner. Does he cower and do nothing or come out swinging? We expect the swinging but do not know in what form.

Forecast

The three big worries are still mostly at the top of everyone’s mind. The chip mania/AI selling frenzy in the stock market may have peaked—we have prices in the green today, starting in the US yesterday and leaking to S. Korea, where the Kospi rose by 17.9% (but is still down on the month). Equity players are shrugging off rising yields, so far. How long can the combination of doubts about the tech sector plus rising yields be ignored? It may well be a double whammy.

Then there is the seeming Hamas deal. This could be one of Trump’s announcements intended to distract from what he is doing, or not doing, with the other hand. Skepticism is at 99.9%. Meanwhile, the US struck Iran again yesterday and today the IRGC claims to have attacked Kuwait. In other words, no progress.

That leaves Warsh and the Fed. Warsh has to act, and soon, and without convoluted, confusing messaging. The market wants to believe in the Fed, despite all the “behind the curve” complaints over the years.

Then there is the strong background factor of economic growth. Over long periods, growth and the fate of a currency are correlated. The US has stronger growth than any other developed country. We just got the Q3 estimate from the Atlanta Fed—a whopping 5%! Europe, UK and Japan are lucky to get 1-2%.

Australia, New Zealand and Canada will do better, but not 5%. (StatCanwill release GDP for May and estimate for Q2 this morning. The BoC expects Q2 to deliver 2.5%.).

All this pondering is in aid of deciding whether the dollar collapse will persist. Goldman and Morgan Stanley like the move and see the euro higher to 1.1500 or more. We must agree that this is what the chart indicates. We simply do not get a reversal breakout of this size that lasts only a day or two. How long it will last depends on whether you like forecasting tools like the Fibonacci retracements and various bands and channels. The standard error channel for Aug 4 lies at 1.1631. We can’t expect much more, but if you like the Fib, the 50% retracement lies at 1.1707.