By Arif Husain, head of global fixed income at T. Rowe Price
While unrest in the Middle East and artificial intelligence optimism continue to drive markets, the Federal Reserve’s (Fed) first policy meeting with a new chair has largely travelled under the radar.
The relatively limited discussion of this important change has largely focused on the short‑term crosscurrents of shifting attitudes toward current monetary policy in light of more persistent inflation. However, there are potentially longer‑term significant implications for markets from this transition.
At his Senate confirmation hearing, Fed Chair Kevin Warsh advocated for structural changes in how the central bank manages monetary policy. His stated aims include reducing the size of the Fed’s nearly $7trn balance sheet and eliminating the dot plot and other forms of forward guidance. Long-term, I think these measures would have the unintended consequence of increasing both implied and realised market volatility.
Post‑GFC Fed policy has reduced volatility
Many investors have been rewarded since the global financial crisis (GFC) for betting on lower volatility by selling options or through other strategies that benefit from falling volatility. For example, narrowing credit spreads are implicitly a play on falling volatility.
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The Fed’s post‑GFC monetary policy, including large‑scale quantitative easing, has been particularly impactful in lowering volatility. The now‑renowned ‘Fed put’ saw the central bank inject substantial liquidity and provide forward guidance that anchored inflation expectations and reduced the tails of the distribution of potential outcomes.
While other market structure factors have also been meaningful in lowering levels of market volatility, it has been the Fed and other global central banks that have been the main drivers. Their actions drove lower volatility in rates, which led to lower volatility in credit markets and then equities.
The risk of withdrawing forward guidance
A Fed effort to further reduce its balance sheet, coming after the central bank ended its latest quantitative tightening programme in late 2025, should cause the market to rethink the longstanding expectations for falling volatility. Withdrawal of forward guidance, including the dot plot, would have the same effect by obscuring the Fed’s monetary policy outlook and opening up a broader range of possibilities. While by no means perfect, the dot plot helps lower expectations for extreme outcomes.
Warsh’s desire to shrink the balance sheet also runs counter to one of the Trump administration’s goals: keeping interest rates as low as possible. We saw the sensitivity of the administration to higher Treasury yields in the reaction to ‘liberation day’ when it later walked back its punitively high tariffs.
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More recently, in January, President Trump directed Fannie Mae and Freddie Mac, which provide liquidity to the real estate market, to buy $200bn of mortgage‑backed securities to help push mortgage rates down.
Suppressing yields – a form of financial repression achieved through government intervention or regulation – can distort government bond markets and keep volatility lower than it otherwise would be.
Contradictory forces set to raise volatility
Of course, the US is not the first economy to flirt with a form of financial repression. The Bank of Japan’s (BoJ) yield curve control programme was one of the longest‑lasting, running from 2016 into 2024. The BoJ bought unlimited amounts of Japanese government bonds to cap the 10‑year yield at 0%, later changed to 1%.
The point here is there needs to be clear coordination between the central bank’s balance sheet strategy and the government’s fiscal strategy. On the face of it, that will not be the case, likely leading again to more volatility and potentially higher yields.
All of these sometimes contradictory forces will likely generate higher volatility in the medium term and beyond.
Falling or constrained volatility has anchored many of the most successful investment approaches over the past decade or more. The next decade is unlikely to be the same.
