The economist Milton Friedman is said to have likened central bank policymakers to “a fool in the shower.”
When the water from the shower is too cold, we turn on the hot tap to compensate. Most of us know that it takes the boiler a few seconds to ignite and get up to temperature, so we wait to feel the ultimate effect of our tap-turning before taking further action. But the fool reacts purely to the fact that the water still feels cold. He cranks the hot tap fully open, enjoys a blissful three seconds of “just right” water—and then gets scalded.
After more than 10 years providing guidance in both words and actions, central banks now feel forced to abandon this approach and set policy purely in response to economic data. There’s an argument that this could reduce volatility because it raises the bar for how far data has to diverge from expectations to spur a policy response. But we think it also risks central banks becoming like the proverbial fool in the shower—and we think this change in behavior spells volatility for financial markets over the coming months, making it especially important to maintain discipline in your investment process.
At last week’s policy meeting, the U.S. Federal Reserve raised rates but, in a move that Chair Jerome Powell described as “meaningful” and indicative of a more “data-dependent approach,” it dropped its guidance that “some additional policy firming may be appropriate.”
The European Central Bank combined a slower pace of rate hikes with some continued guidance on further tightening to come—but that is essentially about catching up with the Fed, and we anticipate a similar shift to being “data-dependent” as the gap closes.
This will be quite different from market participants’ experience over the past 14 years.
Between 2009 and 2022, central banks were clear in their own minds and in their communications about what was required: That era was characterized by statements about doing “whatever it takes,” and forcing low rates on a sometimes skeptical market via quantitative easing. For the past year, they have been equally clear about the need to keep tightening until there are signs that inflation is on a path back to target, even if it means enduring some pain.
Now, they acknowledge that they lack confidence about whether the taps are set too hot or too cold. They will therefore react to how the water feels—even though they also know that they are watching economic data that is weeks or even months out of date, and may be responding to last quarter’s rate hikes or last year’s.
This is honest rather than foolish—while everyone has their opinion about what should be done, it’s not so easy when you are “the person in the arena” at the end of a Great Moderation. But it does put central banks in the same position as the fool in the shower.
Dipping In and Out
And they are not the only ones.
At the risk of over-extending the analogy, imagine a large gym with multiple shower cubicles. You and your fellow gym-goers find yourselves in a situation where a single “fool” is controlling all the taps. Now instead of one person reacting to the fluctuating temperature, everyone has to guess how the tap-controller will react and try to duck in and duck out of the shower, all at the same time.
This is where financial market participants find themselves when central banks go “data-dependent,” and it makes every data release a “set piece” with the potential for volatility around it.
We’ve already seen this to some extent. In the first quarter, for example, over a two-week period from March 8, a series of releases suggested that U.S. inflation was cooling and the economy slowing, and expectations for the euro and U.S. dollar terminal rates declined by over 50 basis points and 90 basis points, respectively. But a month later, on April 14, as my colleague Rob Dishner has put it, the 434 people surveyed by the University of Michigan on inflation expectations pushed market sentiment the other way, managing to move the price of the 10-year Treasury by nearly 1%.
Discipline With Risk Budgets
What might all this mean for investors?
First, we think it means more volatility as market participants dip in and out. As Erik Knutzen observed last week, the CBOE Volatility Index (VIX) for equity markets is signaling much more calm in equities than the bond-market equivalent, the Merrill Lynch Option Volatility Estimate (MOVE), but that is likely because bond markets are the first to feel the temperature fluctuations generated by central banks. We think the volatility will eventually spread to equities.
Second, we think this will generate greater dispersion of active-manager performance, especially among those that take a more opportunistic or tactical approach. There are likely to be more opportunities to substantially outperform (or underperform) the market.
But, third, we believe that achieving long-term outperformance will require humility about what we don’t know and discipline with risk budgets. We could see more of the investors who are running leveraged balance sheets, or processes that are not risk-aware—perhaps a U.S. regional bank, maybe one or two global macro funds—slipping on the shower-cubicle tiles and ending up in the emergency room.
Portfolios that have recognized the change in landscape and actively managed risk appear to have done better so far this year. And with more than 70% of long-term returns driven by strategic asset allocation, investors may want to either to look through this volatility or position, in a risk-disciplined way, to benefit from it. There will still be signals amid the noise. As we highlighted in our most recent Asset Allocation Outlook, long-term investors are currently being “paid to be patient” and carefully identify the valuation and price points where they “would be comfortable re-entering the market as it goes through trough-formation”—as opposed to trying to dip in and out of the shower.
You may not end this year with performance smelling as sweet as you’d like, but it’s better than getting scalded or having to nurse a broken elbow.
In Case You Missed It
- ISM Manufacturing Index: +0.8 to 47.1 in April
- Eurozone Consumer Price Index: +7.0% year-over-year in April
- JOLTS Job Openings: -384k to 9,590k in March
- ISM Services Index: +0.7 to 51.9 in April
- Federal Open Market Committee Decision: The Federal Reserve raised interest rates by 25bps
- China Manufacturing Purchasing Managers’ Index: -0.5 to 49.5 in April
- Eurozone Producer Price Index: +5.9% year-over-year in March
- European Central Bank Policy Meeting: The ECB raised interest rates by 25bps
- U.S. Employment Report: Nonfarm payrolls increased 253.0k and the unemployment rate decreased to 3.4% in April
What to Watch For
- Wednesday, May 10:
- U.S. Consumer Price Index
- China Consumer Price Index
- China Producer Price Index
- Thursday, May 11:
- U.S. Producer Price Index
Investment Strategy Group