“It is a problem of their (the Fed’s) own making. They can’t have it both ways,” said Martin Barnes, chief economist at BCA Research. “If they want to sustain zero interest rates and push up asset prices, how can they expect to have that with no excesses and no risk taking?”, Wall Street Journal

The Fed has given root to the sense of calm by offering investors assurances that interest rates will stay low far into the future. Its policy statement says officials expect to keep short-term rates near zero for a “considerable time” after the bond-buying program, known as quantitative easing, ends later this year. The policies are in place to invigorate a soft U.S. economy, and officials show no sign of veering from the plan. Fed officials face a double-edged sword. Officials want to keep interest rates low to boost economic growth and hiring and to lift inflation from levels below the bank’s 2% target. But, having been burned by the risk taking that stoked the 2008 financial crisis, they are on the lookout for signs that the policies are having dangerous side-effects in financial markets. …Some measures suggest the market has taken the Fed’s assurances further than the central bank intended.”, Jon Hilsenrath, “Fed Worried Calm Markets Forecast a Storm to Come”, Wall Street Journal, June 4, 2014

Economy

Fed Worried Calm Markets Forecast a Storm to Come

By Jon Hilsenrath

Federal Reserve officials are starting to wonder whether a tranquillity that has descended on financial markets is a sign that investors have become unafraid of the type of risk that could lead to bubbles and volatility.

The Dow Jones Industrial Average, up a steady if unspectacular 1% since the beginning of the year, has consolidated big gains registered last year. The VIX, a measure of expected stock-market fluctuations based on options trading, has gone 74 straight weeks below its long-run average—a string of steadiness not seen since 2006 and 2007, before the financial crisis and recession.

Moreover, the extra return that bond investors demand on investment-grade corporate debt over low-risk Treasury bonds, at one percentage point, hasn’t been this low since July 2007. The lower this “spread,” the less risk-averse are bond investors.

The Fed’s growing worry—which could influence future interest rate decisions—is that if investors start taking undue risk it could lead to economic turbulence down the road.

“Volatility in the markets is unusually low,” William Dudley, president of the Federal Reserve Bank of New York and a member of chairwoman Janet Yellen’s inner circle, said after a speech last week. “I am a little bit nervous that people are taking too much comfort in this low-volatility period. As a consequence, they’ll take more risk than really what’s appropriate.”

One example of increased risk taking: Issuance of low-rated U.S. dollar-denominated junk bonds last year hit a record $366 billion, more than twice the level reached in the years before the 2008 financial crisis, according to financial-data provider Dealogic.

Richard Fisher, president of the Federal Reserve Bank of Dallas, added to the chorus of concern over complacency in an interview Tuesday. “Low volatility I don’t think is healthy,” he said. “This indicates to me a little bit too much complacency that [interest] rates are going to stay at abnormally low levels forever.”

Many officials appear more inclined to talk about market risks than act to pre-empt them given the worry about cutting off a fragile recovery with early interest-rate hikes. Though risk-taking is on an upswing, they don’t see a buildup of serious threats to the broader stability of the financial system.

Fed officials are expected at their June meeting to keep gradually scaling back their purchases of mortgage and Treasury bonds and stick to the plan to keep short-term interest rates near zero, where they have been since late 2008.

The Fed has given root to the sense of calm by offering investors assurances that interest rates will stay low far into the future. Its policy statement says officials expect to keep short-term rates near zero for a “considerable time” after the bond-buying program, known as quantitative easing, ends later this year. The policies are in place to invigorate a soft U.S. economy, and officials show no sign of veering from the plan.

Fed officials face a double-edged sword. Officials want to keep interest rates low to boost economic growth and hiring and to lift inflation from levels below the bank’s 2% target. But, having been burned by the risk taking that stoked the 2008 financial crisis, they are on the lookout for signs that the policies are having dangerous side-effects in financial markets.

“It is a problem of their own making. They can’t have it both ways,” said Martin Barnes, chief economist at BCA Research, an investment-advisory firm. “If they want to sustain zero interest rates and push up asset prices, how can they expect to have that with no excesses and no risk taking?”

Some measures suggest the market has taken the Fed’s assurances further than the central bank intended.

Fed funds futures contracts traded on the Chicago Mercantile Exchange indicate investors expect the Fed’s benchmark federal funds interest rate to average 0.6% in December 2015, up from near zero now. That is notably below the 1% rate that is the median of projections released by Fed officials after their March meeting. Futures markets indicate investors expect a 1.6% fed funds rate in December 2016, below the Fed’s own median projection of 2.25%.

Ms. Yellen gently pushed back on the market’s sense of certitude in a mid-April speech at the Economic Club of New York in which she emphasized the unknown. “It is important to note that tying the response of policy to the economy necessarily makes the future course of the federal funds rate uncertain,” she said.

But risk premiums on bonds haven’t budged since.

The market’s calm was a subject of some discussion at the Fed’s April policy meeting, according to minutes of the meeting released last month.

Last year showed Fed officials the potential trade-offs they face. Volatility and risk premiums were similarly low early in the year, making some officials become uncomfortable that investors expected the Fed’s bond purchases to go on longer than the Fed planned. Then, when officials in May started openly discussing ending the program, investors were caught off guard and rates rose quickly, knocking the housing recovery off course.

“I cannot tell you for sure when this does get unwound,” Mohamed El-Erian, former chief executive of the bond fund Pacific Investment Management Co., or Pimco, said in an interview of the recent period of market calm. “When it does we are going to be reminded of what happened last May and June.”

Kansas City Fed President Esther George—like Mr. Fisher a skeptic of the benefits of the central bank’s easy-money policies—wants the Fed to raise short-term interest rates more aggressively than planned to head off financial risks. She remains in a minority.

“My concern is that keeping rates very low into late 2016 will continue to incentivize financial markets and investors to reach for yield in an economy operating at full capacity, posing risks to achieving sustainable growth over the longer run,” she said Tuesday in a speech in Breckenridge, Colo.

—Michael S. Derby contributed to this article.

Posted on June 5, 2014, in Postings. Bookmark the permalink. Leave a comment.

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