Knowing The Policy Stance Of An Incoming Fed Chairman, How It Paid To Do The Opposite

With the appointment of the next Fed Chairman imminent, the WSJ investigated whether knowing his/her identity and policy stance would have led to successful investment decisions. Spoiler alert – it’s often paid to do the opposite.

As The Wall Street Journal reports, President Donald Trump’s The Apprentice-style hiring process for the Federal Reserve chair is due to end this week, and it looks like the message to Janet Yellen is: “You’re fired!” Jerome Powell, a Fed governor, is the leading candidate to take the world’s leading economic job—and he isn’t an economist. Investors following the process have been raking over the past pronouncements of the five main candidates, in an effort to understand the direction of Fed policy over the next four years. History suggests that it is tough to make money from betting on a new chairman’s hawkishness or dovishness, even if you knew who it was going to be. Political betting site PredictIt has Mr. Powell’s chances at 80%, with Ms. Yellen at 8% and academic economist John Taylor at 7%. Outsiders include former Governor Kevin Warsh ; Federal Reserve Bank of Minneapolis President Neel Kashkari ; and Gary Cohn, Mr. Trump’s top economic adviser.

Assuming an incoming Fed Chairman’s identity is known, the WSJ argues that the “most obvious ways to make money” would be trading Treasuries, the dollar and gold. Okay, we won’t disagree with that, but how about back-testing some prominent examples. Paul Volcker should have been relatively straightforward, shouldn’t he? This is what the WSJ found...

The clearest example of bets on a Fed chair was in August 1979, when President Jimmy Carter appointed the hawkish Paul Volcker in a sharp break with his predecessor during the inflationary 1970s. Investors expected Mr. Volcker to tackle runaway inflation with tighter monetary policy, meaning higher short-term rates, and they were right. But after his appointment, many bet that a Fed chair committed to bringing down inflation meant lower long-term bond yields, a lower gold price and a stronger dollar. They made money for about two weeks, before being crushed.


As inflation soared Mr. Volcker stayed true to forecasts, and short-term rates peaked at 22%, the highest ever, pushing the U.S. into double-dip recessions. Contrary to the expectations of investors, bond yields also jumped, with the 10-year reaching almost 16% in 1981, and far from falling, there was a bubble in the price of gold. Gold was at $304 on the day Mr. Volcker was nominated and fell to $282 as investors bet on his hawkishness. Just five months later gold had nearly tripled to $835, the dollar was weaker and the early Volcker trade was dead and buried. Mr. Volcker’s appointment was a case of investors getting the policy positioning of the new chairman right, but their bets on what that meant for asset prices wrong, at least over the next few years.

Bad Bets on Volcker

What about the “Maestro”? The Journal sets the scene when the (then) Ayn Rand disciple was appointed.

Alan Greenspan’s selection was a quite different matter. Conservatives welcomed his appointment in 1987, thinking he shared the hawkish inflation-fighting mind-set of Mr. Volcker, his predecessor. The main point of difference was Mr. Greenspan’s willingness to support financial deregulation—something now espoused by Mr. Powell.

As we remember only two well, however, Greenspan changed his spots as the WSJ notes...

Mr. Greenspan does seem to have started out hawkish, raising new concerns about inflation at his first Fed policy meeting, according to the transcript. But his hawkish credentials lasted just two months, until the Black Monday stock market crash of October 1987.


The new Fed chairman said the central bank stood ready to “serve as a source of liquidity”—thus ushering in the infamous “Greenspan put,” the idea that the Fed would step in to support markets in a crisis. A repeat after the Russian default and Wall Street chaos of 1998 helped fuel the final stages of the dot-com bubble, and many believe that Mr. Greenspan pushed up rates too slowly and too predictably during the 2000s, contributing to the excessive risk-taking that ended in the 2008 crisis.


Investors might have been wrong about Mr. Greenspan’s commitment to tight money, let alone his devotion to the views of right-wing novelist Ayn Rand, but they were right about his support for financial deregulation.

Ironically, current candidate, John Taylor, was not a fan of “Easy Al’s” policies, which stoked the bull market in gold and bear market in the dollar during the 2000s. The WSJ continues...

One prominent critic of the Fed’s pre-crisis policies is Mr. Taylor, whose “Taylor rule” suggested rates should be higher during the 2000s. The market backed up his view: Gold prices began to rise and the dollar fall from 2002, when the Fed set rates well below what the Taylor rule suggested for the first time since the 1970s. Democratic and Republican presidents stripped the financial sector of the burden of rules introduced in the Great Depression, working wonders on the sector’s share prices—at least for a while. By the time Mr. Greenspan left office in 2006 the U.S. financial sector was up 653% since his 1987 appointment, gaining more than double the 319% of nonfinancial stocks, according to Thomson Reuters Datastream.

The Maestro’s legacy was tainted shortly afterwards.

Having concluded that knowing whether an incoming Fed Chairman is hawkish or dovish was essentially a contraindicator for asset allocation, the WSJ discusses current front runner, Jerome Powell.

We can tentatively say two things about Mr. Powell, assuming he is appointed: he will be friendlier to Wall Street than Ms. Yellen, and he will take a similarly dovish approach to monetary policy. In the short run, less red tape will support bank stocks a bit, but banks surely won’t return to their wild pre-crisis leverage any time soon. Equally, a continuation of Ms. Yellen’s cautious approach to rate increases will avoid shocking the market, while leaving unchecked the danger that a bubble develops in the already-expensive stock market. Given investors’ dire history of predicting how Fed chairmen will use their power, the wisest approach may be to wait and see how he turns out.

So, using the WSJ’s insights, we might invest on the basis that Powell will be anti-Wall Street and hawkish? If so, we are struggling to think of asset classes which aren’t horrendously mispriced at this point.