Fed Has Put Markets in Survival Mode
There's a big debate in markets about the appropriate Federal Reserve policy amid conflicting signals. With the jobless rate at 4.4 percent, the trade-off between growth and inflation known as the Phillips curve would seem to matter.
Yet the wage pressure that logically should have come by now is elusive, probably because of technology-driven disinflation. Just look at the Fed's preferred gauge of prices, the core personal consumption expenditure index, which is trending lower. The latest reading of 1.4 percent, for May, fell further below the bank's 2 percent target.
So, is the Fed "tightening into a slowdown?" The question, while not irrelevant, misses the point. The central bank's problem is that although it has an economic mandate, its policies have vastly more impact on financial markets. Interest rates this low for this long are far less important for economic growth than they are for corporate profits, asset prices and carry trades. And while the trajectory of its policy rate is higher, the Fed's careful guidance amounts to a promise that the pace of change will remain both modest and predictable.
This carries two meaningful risks. First, absent a change in the return profile of "safety," the opportunity cost of not being allocated to riskier assets -- stocks, credit, real estate, carry trades and so on -- becomes intolerably high. The value proposition of the developed sovereign bond market is highly unappealing: In Germany, inflation outstrips nominal 10-year bund yields by about 1 percentage point; and while not priced as egregiously, real 10-year Treasury yields in the U.S. are merely 60 basis points.
Sitting on the sidelines and waiting for more favorable prices before deploying capital may sound logical. But just try being defensively positioned when the cost of doing so is so high for so long. Former Fed Chairman Ben Bernanke's portfolio balance channel is indeed a powerful construct for this, forcing risk-taking as a not-as-bad alternative to owning "risk-free" assets at distorted prices.
Coupled with its role in cultivating exceptionally low rates, the Fed has a part in creating a second risk: unreasonably low volatility. Among the biggest bets in markets is a class of trades that can be broadly characterized as "more of the same."
The Fed, by carefully articulating what's coming next, is the chief sponsor of the trade. Equity market risk is low? “More of the same” is a deeply embedded view as captured in the melting prices of VIX futures. The Fed's timeline is gentle? Look no further than the declining expectations of 2018 rate hikes. The China/U.S. currency relationship is money good? Foreign-exchange option prices provide little basis to disagree.
Across major asset classes, the excessive visibility that the Fed bestows on markets manifests itself in low option prices and the way in which investors are being drawn to sell insurance against big market moves at increasingly risky levels.
Implied volatility, the central driver of an option's price, represents a margin for error. Periods of high implied volatility, such as the five-year stretch from 2007 through 2011 when the VIX averaged 25.7, reflect the market's assessment that options are valuable because they provide rights without obligations. An investor has little reason to pay for the right to change his or her mind when future outcomes already appear obvious. This is today's world of sagging option prices. Across foreign-exchange, rates, equities and credit, implied volatility levels are comparable to those of the pre-crisis period. Then, as now, the right to change one's mind was judged to have little value. In early 2007, as the crisis was being set in motion, this right could not have been more mispriced.
And this is where the Fed comes in. Its dual mandate of fostering full employment and price stability is perfectly reasonable. Yet its failure to acknowledge and appreciate how profoundly its policy stance and forward guidance influence risk-taking is increasingly irresponsible.
Easy money is being made on the premise that the market will continue to march forward in stable, unperturbed fashion. It is impossible not to participate in this carry trade in all its manifestations. Sometimes characterized as complacent, market participants are more aptly described as engaged in institutional survival, selling volatility because they are forced to do so. In a low interest rate environment in which return is so challenging to manufacture, there is no real alternative.
In an interview last week, Fed Chair Janet Yellen expressed confidence that markets would not experience another large crisis "in our lifetimes." Her optimism is difficult to embrace, especially given the central bank's ongoing pursuit of economic objectives with policy tools that have far too much impact on how investors take risk. Eight years after the crisis, perhaps low rates don't cause price inflation. When coupled with low volatility, low rates do force a certain kind of risk-taking, however. The Fed needs to understand that by continuing to escort markets on such a carefully guided tour, the sponsorship of carry trades will only increase.
The Fed missed this entirely a decade ago. Will it repeat the same mistake?
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Max Berley at firstname.lastname@example.org