Canada's post-2008 playbook shows the volatility risks of Warsh's no-guidance Fed

Kevin Warsh has a straightforward approach to forward guidance from the Fed: He isn't going to provide any.

After Mark Carney settled markets with explicit forward guidance and successfully shepherded Canada through the global financial crisis in 2008, his successor as central bank governor changed course. Guidance was dialed back and the communication of monetary policy tinkered with, the upshot of this being higher volatility for the Canadian dollar (USDCAD) and what Goldman Sachs called "growing pains" as bond-market participants adjusted to the new approach.

A report from Goldman Sachs economists Michael Cahill and Lexi Kanter published Tuesday assessed the impact that even small communication changes can have on forex volatility and concluded that the shift in approach from Warsh is liable to "translate into higher front-end volatility and potentially cause "more market misfires" as investors recalibrate their response to a new Fed Chair.

The Goldman note also found that, with different governors at the helm, markets tend to emphasize different features of their leadership. Under former Fed Chair Jerome Powell, for instance, bond markets tended to be more reactive to his press conferences rather than the policy bias from statements by the Federal Open Market Committee.

Compared with the Bernanke and Yellen eras, post-FOMC press conferences under Powell generatedhigher intraday FX volatility.

Powell's era was characterized by higher volatility after press conferences, compared with those of predecessors Ben Bernanke and Janet Yellen. Moreover, committee disagreements, usually reflected by "hidden dissents" (when board members disagreed with the outcome), also increased volatility after subsequent data releases.

It's the forward guidance, or rather the absence thereof, that Cahill and Kanter focused on. Carney's replacement in 2013 at the Bank of Canada was Stephen Poloz, who maintained that by withdrawing the guidance, the private sector would focus more on the economy and "better reflect what the Bank should do, rather than what it would do," the economists said.

Comparing the final year of Carney's term to the first year of Poloz's, CAD implied volatility became more idiosyncratic, and less correlated to implied volatility in other G10currencies and global factors

As a consequence, even though the loonie is generally considered a fairly stable currency, its volatility increased relative to those of other G9 countries. (That's G7, plus Australia and South Korea.) Not only did realized or actual volatility rise, but implied volatility (the market's forecast, essentially) became "more idiosyncratic" and less correlated with other G10 currencies.

The Goldman economics team also said that changes in the preferred measure of inflation, something Warsh is exploring, can be detrimental if market participants and policymakers are not in sync. It's even more important for the Federal Reserve than it was for the Bank of Canada, the note said, because the dollar's DXY global role means surprises can have wide-ranging ramifications for the market.

With the Fed's next policy decision set for Sept. 15-16, bond markets currently ascribe a 48% probability to an increase in the target rate (FF00) of 25 basis points. In Tuesday morning trading, U.S. 2-year notes BX:TMUBMUSD02Y were yielding 4.25%.

-Jules Rimmer