Investment Review №353. In Search of New Landmarks

The market held its breath for Kevin Warsh’s first major Jackson Hole speech, eager to know what would happen with rates and when. Yet Warsh again rejected the approach that has defined recent years, with the Fed pre-positioning investors ahead of each policy decision. In his view, markets should not build every trade around the next line from the central bank—they should price the data and make their own call. At first glance, the approach looks risky. Less forward guidance from the Fed means more uncertainty around the policy path. And the immediate market reaction was clear: the probability of a rate hike at the next meeting rose from ~40% to ~60%, while the 2Y U.S. Treasury yield climbed from 4.24% to 4.36%. But the real takeaway was the market’s lack of stress. The VIX ended the week below 14.5, near a 1-year low, while rates volatility also eased. Ultimately, investors found themselves in a long-forgotten regime: real uncertainty, paired with a market that wasn’t fazed by it.

In my view, this adds to the Fed’s monetary-policy toolkit in a meaningful way. In recent years, investors have become accustomed to a de facto “Fed dependency”: the Fed provides guidance, markets reprice accordingly, and the Fed then uses those market prices as a read-through on financial conditions. This creates a circular feedback loop, with the magnitude and direction of the Fed’s influence increasingly difficult to disentangle. Warsh’s objective is to break that loop. The result should be a cleaner read on the market’s aggregate reaction function, capturing not just the “Don’t fight the Fed” dynamic, but also the positioning and actions of other market participants, incoming macro data, and broader cross-asset signals.

Certainly, a rate hike could trigger a negative market reaction, but our analysts are by no means expecting a rate hike next week. First, inflation is elevated, but it is not feeding into inflation expectations. That reduces the urgency for additional tightening and gives the Fed room to stay on hold. Second, a hold would actually reinforce Warsh’s core message: markets need to get better at interpreting the Fed rather than relying on explicit policy guidance. The cleanest way to cement that shift is arguably to do the opposite of what markets have come to expect—withhold a hike and force markets to price the policy path independently. Third, financial conditions are already sufficiently tight. The market has been pricing a debt problem, not an inflation problem, pushing Treasury yields materially higher without any change in the policy rate. Since the start of the year, yields have risen by ~40–100bps across the Treasury curve. Against that backdrop, even a 25bps hike would likely have limited incremental impact on Treasury yields. And with the rates market already doing much of the Fed’s tightening work, the knock-on effect on equities should be similarly contained.

In addition, the logic that volatility should rise amid “foggy” Fed communication doesn’t really hold up in practice. The options market shows that fear right now is largely deferred to the future. Short-term volatility on the S&P 500 has fallen close to its yearly lows, while the spread between one-year and one-month volatility sits at a historic high. The reason was laid out in our previous piece—large debt and long-term concerns about servicing it. Otherwise, short-term volatility would have risen in step with the higher probability of a rate hike next week. This is precisely the nuance Warsh was after: a signal that isn’t dictated by the regulator, one the Fed can actually use in its own work.

The U.S. economy, despite its challenges, remains in solid shape, and tightening policy into a strengthening economy is textbook macro. Record corporate earnings provide real-world confirmation. That said, for investors concerned about the durability of the S&P 500 rally, it may make sense to consider downside protection via puts on the S&P 500 ETF (SPY), which currently look relatively inexpensive. Seasonality adds to the case: September is historically one of the weakest months for equities. Against that backdrop, a 2M put struck around current levels, sized at ~1-2% of the portfolio, looks like a relatively cheap hedge for existing equity exposure—allowing investors to retain their index positions without having to sell into potential near-term volatility.