With precious metals crashing and the dollar strengthening, is Warsh a friend or foe?

Written by: Long Yue, Wall Street Insights

On Friday, Wall Street experienced a dramatic repricing of assets.

Faced with the prospect of former Federal Reserve Governor Kevin Warsh potentially taking the helm of the Federal Reserve, investors are caught in a deep dilemma: will this new chairman be a "friend" or an "enemy" of the market?

Market confusion was directly reflected in the sharp price fluctuations. On Friday, silver once fell by more than 30%, marking its biggest single-day drop since March 1980; gold once fell by 11%, its worst day since January 1980. Meanwhile, the dollar index surged 0.9%, the 10-year US Treasury yield rose to 4.24%, the S&P 500 index fell slightly by 0.4%, and the Russell 2000 index, which is more sensitive to liquidity, fell 1.5%.

The core of this chain reaction lies in Warsh's seemingly contradictory policy stances. On the one hand, he called for the Federal Reserve to cut interest rates more quickly, while on the other hand, he firmly advocated reducing the Federal Reserve's massive balance sheet (i.e., "quantitative tightening").

Priya Misra, a fixed-income portfolio manager at JPMorgan Asset Management, bluntly pointed out the market's concerns: "People are reacting to his comments about the need to shrink balance sheets. This will have a very big impact on risk assets."

For the market, interest rate cuts are certainly a positive factor, but if they are accompanied by aggressive quantitative tightening, liquidity will be withdrawn. This is the underlying logic behind Friday's market performance, which saw a "double whammy" of safe-haven assets (gold/US Treasuries) and risk assets, with only the US dollar strengthening.

The Shadow of Balance Sheet Reduction: Hidden Worries for Risky Assets

Wall Street’s biggest concern is Warsh’s attitude toward the Federal Reserve’s balance sheet.

Warsh served as a Federal Reserve governor from 2006 to 2011, where he was known as an "inflation hawk" and for years argued that low interest rates and large-scale bond purchases would fuel price increases. Although his recent comments have shifted to support faster rate cuts, his insistence on shrinking the balance sheet has led some investors to believe that this could weaken the stimulative effect of rate cuts.

Currently, the Federal Reserve has just begun to expand its balance sheet again by purchasing short-term Treasury bonds to ease pressure on the overnight lending market. If Warsh reverses this trend after taking office, market liquidity will face a test.

A prominent figure strongly supports him: He's a "pragmatist."

Despite the market's reaction, Wall Street's top investment circles are not unanimously bearish. Many seasoned investors believe that Warsh's greatest value lies in his "independence." Compared to the "standard-bearer of loose monetary policy" previously demanded by President Trump, Warsh is seen as the right person to withstand political pressure and maintain the central bank's independence.

Rob Arnott, founder of Research Affiliates, said: "Wash is a pragmatist. He will be a rational voice, which will have a calming and soothing effect on the market."

Hedge fund manager Paul Tudor Jones praised him highly, calling Walsh "very market savvy." Jones believes, "With debt exceeding 100% of GDP and a deficit rate of 6%, he is the perfect person to guide us through this potentially challenging period."

Pimco's Chief Investment Officer, Dan Ivascyn, also reassured the market, saying, "The market will be comfortable with this choice; he will demonstrate sufficient independence."

The logic of "currency devaluation trading" is reversed.

From a trader's perspective, Friday's market action also revealed a shift in logic. The previous record highs for gold and silver largely reflected a loss of market confidence in the US dollar and US assets (i.e., "currency devaluation trading").

However, Warsh's emergence seems to have reversed this expectation. Friday's strong rebound in the dollar, coupled with the collapse in precious metals, suggests that investors are withdrawing this "vote of no confidence." Peter Boockvar, chief investment officer at OnePoint BFG Wealth Partners, summarized this uncertainty amidst complex emotions with a pun:

Will the real Kevin Warsh step up?

All the current market fluctuations are essentially betting on "who is the real Kevin Warsh." His policy stance is complex and difficult to discern: once a well-known "inflation hawk," he has recently shifted to calling for interest rate cuts, yet he remains fixated on quantitative tightening. This complexity renders any simple "dovish" or "hawkish" label pale and powerless.

It is worth noting that even if Walsh takes office, he will not be able to formulate policies on his own.

While the Federal Reserve Chair wields considerable influence, he is still subject to the committee's voting mechanism. Currently, divisions have emerged within the Fed. This week, the Federal Open Market Committee (FOMC) voted to keep interest rates unchanged, but two governors appointed by Trump, Waller and Milan, voted against a 0.25 percentage point rate cut.

Some investors point out that if the US central bank leaders and committees frequently disagree on interest rate decisions, as they have in the UK, it would signal a significant shift and could put pressure on markets by increasing uncertainty about future decisions.

Clearly, Wall Street needs more time to digest the complex signals brought by this potential new chairman.