Ebbing Market Risk Gives Fed the Option to Delay TaperingAki Ito
Federal Reserve policy makers have wrung out some risk in financial markets by signaling plans to wind down $85 billion in monthly bond purchases, buying time to press on with record stimulus should the economy need it.
A range of market risk measures have fallen since May 22, when Chairman Ben S. Bernanke said the Fed may consider tapering purchases “in the next few meetings” if the labor market shows signs of sustainable gains. The value of the largest leveraged loans has fallen 0.6 percent, and speculative-grade debt sold by companies has dropped by more than half since the start of June, compared with the prior two-month period.
Reduced risk-taking has probably eased concerns on the Federal Open Market Committee that bond buying known as quantitative easing may trigger financial-market instability, said Julia Coronado, chief economist for North America at BNP Paribas in New York.
Signs of investor caution will “quiet some of the discomfort with QE, and make some people on the FOMC more patient” about the timing of a reduction in purchases, said Coronado, a former economist at the Fed’s Division of Research and Statistics. San Francisco Fed President John Williams voiced relief last month that bond market “froth” was receding.
The FOMC today may clarify its plans to cut and eventually halt asset purchases in a statement at the end of a two-day meeting, Coronado said. The panel will probably wait until September to reduce the monthly buying by $20 billion to a total of $65 billion, according to half of the 54 economists surveyed July 18-22 by Bloomberg News.
A decline in risk-taking addresses one of the chief concerns of policy makers about the potential hazards from bond purchases that pushed up the Fed balance sheet to a record $3.57 trillion as the central bank sought to reduce unemployment and spur growth.
When officials assess the potential drawbacks from quantitative easing, “the one we have paid the most attention to is financial stability,” Bernanke said in July 18 testimony to the Senate Banking Committee.
The unwinding of “leveraged and perhaps excessively risky positions” is “a good thing” that would “probably make more FOMC participants more comfortable with using this tool going forward,” Bernanke said. At the same time, the accompanying tightening in financial conditions is “unwelcome,” he said.
Bond yields surged in May after policy makers, including Bernanke, began signaling that they may soon consider reducing monthly asset purchases. Bernanke said on June 19 that the FOMC is on track to start scaling down the program later this year and halt it around the middle of 2014 as long as the economy performs in line with the committee’s expectations.
The yield on the 10-year Treasury note rose on July 5 to 2.75 percent -- close to a two-year high -- from 1.93 percent on May 21, the day before Bernanke commented on the possible timing of tapering in congressional testimony. The yield was 2.68 percent at 8:33 a.m. in New York.
Some investors had expected the Fed to buy bonds and hold the main interest rate at zero for longer than Fed officials anticipated, Williams said on June 28. His remarks echoed comments by Richmond Fed President Jeffrey Lacker and the Dallas Fed’s Richard Fisher, who said on June 4 that investors had realized “this will not go on forever.”
“Investors had built in expectations of more asset purchases than I think the committee taken as a whole was anticipating,” Lacker said to reporters on June 28.
Lacker, Williams and Fisher don’t vote on policy this year.
“The market reaction to me probably is a sign that there was complacency and excesses going on,” Williams said. “It’s a good thing that maybe came to an end, or maybe was lessened.”
The S&P/LSTA U.S. Leveraged Loan 100 Index shows that the largest leveraged loans rose 2.9 percent this year into May and then pared the gain to 2.3 percent after Bernanke’s May 22 congressional testimony. Leveraged loans are rated below Baa3 by Moody’s Investors Service and lower than BBB- at S&P.
The extra yield investors demand for speculative-grade corporate debt over government securities rose to 534 basis points on June 24, from a more than five year-low of 423 basis points on May 9, according to Bank of America Merrill Lynch U.S. High Yield index. The gauge was 466 basis points on July 30.
The Fed’s signals on tapering “caused people to pause and reassess the risk they had on their books,” said Matthew Duch, a fund manager in Bethesda, Maryland, at Calvert Investments, which oversees about $12 billion. Fed officials “want to see two-sided markets,” he said, adding, “it was important that they take a step to even out some of the buying that was going on.”
Investors have shortened their forecast for the duration of Fed stimulus, aligning their expectations for the path of the main interest rate more closely with the Fed. They expect the federal funds effective rate will exceed 50 basis points by June 2015, compared with their May 2 forecast that the rate will hit that level by March 2016, according to implied rates from fed funds futures.
Most policy makers have indicated that they expect to first increase the fed funds rate in 2015, according to projections released after the June 18-19 FOMC meeting. Thirteen FOMC participants expect the main interest rate to be 1 percent or higher by the end of that year.
None of the economists surveyed by Bloomberg expects the FOMC to begin paring its bond purchases at its meeting ending today. The Fed will probably halt the purchases in the second quarter of next year, according to half of the economists. Twenty-four percent forecast the FOMC will end quantitative easing in the third quarter of 2014.
Investors now recognize that the Fed won’t purchase bonds indefinitely, even though some gauges of risk-taking have risen since Fed officials started emphasizing that any tapering will hinge economic data, said Scott Brown, chief economist at Raymond James & Associates in St. Petersburg, Florida.
“People are looking more clearly at the end of the asset-purchase program,” Brown said. “It was enough to shake the markets up and lead to a revaluation in risk perceptions.”
Volatility has waned since Bernanke told a congressional panel on July 17 that he hasn’t put bond purchases “on a preset course” for tapering and will adjust buying based on economic data. Bank of America Merrill Lynch’s MOVE Index, which measures volatility based on prices of over-the-counter options on Treasuries maturing in two to 30 years, has fallen 29.4 percent from July 5 to 83.27.
“There’s a bit of risk-taking still in the market, but I think it’s healthier than it was in May,” said Duch at Calvert Investments. “People are more cautious.”