Fed Easy Credit Becomes Inside Debate Focusing on Escape
Federal Reserve Chairman Ben S. Bernanke says the end of the central bank’s bond buying won’t constitute a move toward tighter policy. He may have a tough time convincing stock and bond investors that’s true.
The Fed is acquiring $85 billion of securities each month, and policy makers are grappling with how to condition markets not to interpret a stop in those purchases as a prelude to the exit from easy credit. Bernanke said Dec. 12 in Washington that he “would emphasize” the end won’t be “a turn to tighter policy.”
If the Fed fails, interest rates may climb prematurely, as traders arrange positions for the withdrawal of unprecedented monetary stimulus, according to Dean Maki, chief U.S. economist at Barclays Plc in New York. The Fed has kept its benchmark federal funds rate near zero for more than four years and swelled its balance sheet to a record of more than $3 trillion through three asset-purchase programs.
“There is a risk the markets get ahead of the Fed,” said Maki, a former Fed board economist. “It will be tricky for the Fed to signal it’s going to stop buying without signaling that tightening is imminent.”
Ending the Fed’s third round of so-called quantitative easing carries greater significance than completion of the previous two because those were introduced with defined amounts and durations.
For QE3, the Federal Open Market Committee in September announced purchases of $40 billion a month in mortgage-backed securities, leaving the program open-ended until the labor market improves “substantially.” In December, the FOMC added $45 billion of monthly Treasury purchases.
Marilyn Cohen, founder of Envision Capital Management Inc. in Los Angeles, said she doesn’t think the Fed will be able to convince traders that interest rates aren’t going up when the central bank stops buying bonds. Cohen said she’s already lowered the interest-rate sensitivity of her $325 million portfolio in preparation.
“The markets are on edge; and any hint that things are changing, and we will see the repercussions,” Cohen said. “I’ve been in this business since 1979 -- I’m one of the old dinosaurs -- and I cannot remember when there was such a chorus in the investment landscape that all are calling for higher rates.”
Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co.; Jim Rogers, chairman of Rogers Holdings; Wells Capital Management Inc. and Goldman Sachs Group Inc. all have voiced concern about long-term bonds.
The Jan. 3 release of the minutes from the FOMC’s Dec. 11-12 meeting illustrates investors’ sensitivity, Cohen said. Central bankers discussed possibly curtailing or halting their asset purchases this year. That surprised analysts and traders, sending the Standard & Poor’s 500 Index down 0.2 percent and pushing up yields on the benchmark 10-year Treasury note 0.07 percentage point that day.
James Bullard, president of the Federal Reserve Bank of St. Louis, says the “communication challenge” the central bank faces with the end of QE3 is comparable to all periods of easing.
“The same thing happens with interest-rate policy; you’re lowering the interest rate, and after a while you decide to quit lowering the interest rate and just hold it steady,” Bullard said in a Feb. 1 interview in Washington. “And at that point, you have to convince markets this is really a lower rate than it used to be.”
U.S. 10-year government notes declined, pushing the yield up two basis points, or 0.02 percentage point, to 1.97 percent at 10:32 a.m. London time. Yields on thirty-year bonds also climbed two basis points to 3.18 percent.
Fed Governor Jeremy Stein warned last week that the market for speculative-grade debt may be overheating even as his institution’s policy of keeping benchmark borrowing costs low is pushing investors into riskier debt.
“We are seeing a fairly significant pattern of reaching- for-yield behavior emerging in corporate credit,” Stein said in a Feb. 7 speech in St. Louis. If the observation is accurate, he said, “it does not bode well for the expected returns to junk bond and leveraged-loan investors.”
Just because the Fed halts its asset purchases also doesn’t mean it couldn’t restart them. Bernanke announced his first quantitative-easing program in November 2008; it ran until March 2010, and QE2 lasted from November 2010 to June 2011.
Bullard said he expects U.S. growth will gain enough momentum to let the central bank reduce the pace of bond buying as early as the middle of the year. The unemployment rate will fall to the “low 7s” by December from 7.9 percent in January, which would meet the FOMC’s test of the “substantial improvement” needed to end purchases, he predicted.
“It is going to be very difficult for them” to end QE3 without triggering a rise in borrowing costs, which may argue for sticking with the program until the economy has sustainable momentum, said Carl Lantz, head of interest-rate strategy at Credit Suisse Group AG in New York.
Japan is one guidepost for Fed officials as they consider how long to keep stimulus in place. The Bank of Japan lifted the benchmark lending rate off zero in August 2000, before an economic recovery had consolidated. Monetary-policy experts, including former Fed Governor Frederic Mishkin, have called that move a “mistake.”
“All throughout the crisis, Japan has been on their mind,” said Mark Gertler, a New York University economics professor who has co-authored research with Bernanke.
Investors eventually will have to take the Fed at its word: The federal funds rate isn’t going to rise until the unemployment and inflation goals are hit, Gertler said. If the economy drifts further away from the thresholds -- as it has in the most recent reports -- then investors should begin to expect a longer period of rates near zero, and that provides continued accommodation.
While the end of QE3 is tied to subjective criteria about the labor market, policy makers have set specific numerical thresholds for raising rates. The FOMC said in December, and repeated in January, that “an exceptionally low range” for its benchmark would be appropriate as long as inflation isn’t forecast to rise more than 2.5 percent and unemployment remains above 6.5 percent. These criteria replaced previous calendar- based guidance that rates would stay near zero at least through the middle of 2015.
“The market is always looking for the next big thing,” said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. “Once the Fed stops buying assets, everybody knows what the next big thing is: the beginning of the exit cycle.”
Even though Bernanke said Dec. 12 that the transition to economic thresholds “doesn’t change our mid-2015 expectation,” money-market-derivatives traders since have accelerated their time frame for policy tightening.
Forward markets for overnight index swaps, whose rates show what traders expect the federal-funds effective rate will average over the life of the contract, signal a quarter percentage-point advance around February or March of 2015, according to data compiled by Bloomberg as of Feb. 5. In December, these traders were pricing in a rate increase about June 2015.
“There is no doubt that when the Fed pulls back you will see a big shoot upward in Treasury yields,” said Karl Haeling, head of strategic-debt distribution in New York at Landesbank Baden-Wuerttemberg, one of Germany’s largest banks. “There are a lot of people who think the only reason rates are here is because the Fed put them here. Nobody wants to be the last man standing.”
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