2 April 2012Asset managementAs far as the market is concerned the Federal Reserve (Fed) hascommitted to keeping the Fed funds rate below 0.25% untilthe end of 2014. Never mind that the Fed statement only saidit ‘currently’ anticipates that rates will need to be ‘exceptionallylow’. Never mind that it said conditions are only ‘likely’ to justify such a move. The market hears what it wants to hear,and what it wants is certainty.We had a total of twelve different speeches from eightdifferent Fed speakers last week. A common theme in thiscommunication blitz was that it is the data, not the date, thatwill determine the Fed’s next move. Clearly the Fed has realisedthat the market has interpreted its indication as a promise andis trying to create a bit more room for manoeuvre. It can try,but so far the market still says that a promise is a promise (evenwhen it was not meant to be).Fed Chairman Bernanke started the week by giving a fairlydovish view on the labour market. For him the recent rapidimprovement is a limited reversal of the unusually highunemployment rates that followed the recession. He alsothinks unemployment is mostly cyclical (temporary) and notstructural (permanent), which is a justification for the Fedto try to increase demand in the economy to deal with thattemporary unemployment. If he was trying to bring yieldsdown, he succeeded. In contrast, Richmond Fed PresidentLacker has been at pains to stress that he thinks the timecommitment is potentially a grave mistake. However, his viewcarries less weight than the Chairman’s.The Fed has reached the limit of what it can achieve withshort-term interest rates because it is hard to cut below zero.With no room at the short end of the curve, the Fed turned tounconventional policy to target the longer end of the curve.Buying longer dated bonds through quantitative easing (QE)obviously brings longer dated bond yields down. Committingto keep rates on hold also works to keep yields down (if thefirst three years of a ten-year bond yield almost zero, theaverage yield will fall).Suppose that the Fed needs to tighten earlier than its commitmentsuggests, maybe because growth is stronger than expectedor inflation picks up too quickly. This is not as easy to rule outas you might think. If the Fed keeps to its end 2014 timeframe andsubsequently hikes rates at the usual quarter-percent per meeting,rates would not get back to the Fed’s ‘neutral’ range of 4–4½%until late 2016. If the Fed sticks to this ‘fastest path’ (see chart 1),that creates a wide window of time for a surprise to come in.
Senior Fixed Income EconomistUBS Global Asset Management firstname.lastname@example.org
Fixed Income EconomistUBS Global Asset Managementgianluca.email@example.com
Source: Federal Reserve, Bloomberg, UBS Global AM
Chart 1: Rate expectations
Fed funds rate according to market expectations based onOIS, ‘fastest path’ based on past Fed behaviour, and FOMCmembers’ range of end-year expectationsDespite what the Fed actually said, markets interpretedits position of keeping rates ‘exceptionally’ low as apromise to stay on hold until the end of 2014, no matterwhat the path of the recovery will be. Because of thisbelief, the Fed might be reluctant to increase rates shouldthe recovery be better than expected. Markets would seethis as a broken ‘promise’, undermining the credibilityof any future pre-commitment. For this reason, the Fedcould opt for subtle approaches aimed at pushing long-term rates up instead. This would generate a historicallyunusual situation where a tightening cycle led to yieldcurve steepening instead of flattening.
Fed end-year projections012345
Market pricing'Fastest' path20162015201420132012