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2 April 2012
Economist Insights Fed up
Despite what the Fed actually said, markets interpreted its position of keeping rates ‘exceptionally’ low as a promise to stay on hold until the end of 2014, no matter what the path of the recovery will be. Because of this belief, the Fed might be reluctant to increase rates should the recovery be better than expected. Markets would see this as a broken ‘promise’, undermining the credibility of any future pre-commitment. For this reason, the Fed could opt for subtle approaches aimed at pushing longterm rates up instead. This would generate a historically unusual situation where a tightening cycle led to yield curve steepening instead of flattening. As far as the market is concerned the Federal Reserve (Fed) has committed to keeping the Fed funds rate below 0.25% until the end of 2014. Never mind that the Fed statement only said it ‘currently’ anticipates that rates will need to be ‘exceptionally low’. 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 eight different Fed speakers last week. A common theme in this communication blitz was that it is the data, not the date, that will determine the Fed’s next move. Clearly the Fed has realised that the market has interpreted its indication as a promise and is 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 (even when it was not meant to be). Fed Chairman Bernanke started the week by giving a fairly dovish view on the labour market. For him the recent rapid improvement is a limited reversal of the unusually high unemployment rates that followed the recession. He also thinks unemployment is mostly cyclical (temporary) and not structural (permanent), which is a justification for the Fed to try to increase demand in the economy to deal with that temporary unemployment. If he was trying to bring yields down, he succeeded. In contrast, Richmond Fed President Lacker has been at pains to stress that he thinks the time commitment is potentially a grave mistake. However, his view carries less weight than the Chairman’s. The Fed has reached the limit of what it can achieve with short-term interest rates because it is hard to cut below zero. With no room at the short end of the curve, the Fed turned to Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management email@example.com
Gianluca Moretti Fixed Income Economist UBS Global Asset Management firstname.lastname@example.org
unconventional policy to target the longer end of the curve. Buying longer dated bonds through quantitative easing (QE) obviously brings longer dated bond yields down. Committing to keep rates on hold also works to keep yields down (if the first three years of a ten-year bond yield almost zero, the average yield will fall). Suppose that the Fed needs to tighten earlier than its commitment suggests, maybe because growth is stronger than expected or inflation picks up too quickly. This is not as easy to rule out as you might think. If the Fed keeps to its end 2014 timeframe and subsequently 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.
Chart 1: Rate expectations
Fed funds rate according to market expectations based on OIS, ‘fastest path’ based on past Fed behaviour, and FOMC members’ range of end-year expectations
5 4 3 % 2 1 0 2012 'Fastest' path 2013 2014 Market pricing 2015 2016 Fed end-year projections
Source: Federal Reserve, Bloomberg, UBS Global AM
The market is not expecting such a rapid tightening, and is pricing in only a small probability that rates will rise before the end of 2014. In contrast, many members of the Federal Open Market Committee (FOMC) think that rates will need to rise earlier than that (see chart 1), with more than half expecting hikes will be needed by the end of 2013. The market is discounting that because they believe that the most influential FOMC members are all at the low end of that distribution. In the event of an upside surprise, the Fed will want to tighten monetary policy but will be reluctant to break its ‘promise’ by raising short-term rates before the end of 2014. The obvious response is to tighten by raising longer-term rates. In other words, put QE into reverse. Stopping reinvestment of maturing bonds, reverse repo operations or simply selling treasuries back to the market would all work to push up long-term rates quite quickly. Longer-term yields would rise but short-term rates would be constrained by the Fed funds rate. This would be a markedly different situation to the previous tightening cycles. Traditionally, during a tightening cycle the yield curve flattens (see chart 2). In other words, short-term rates rise by more than long-term rates. Reversing QE while holding rates constant could actually steepen the curve, breaking from past market experience.
Chart 2: Flat out?
There are some other, more subtle approaches available to the Fed that avoid breaking the ‘promise’ on rates. It could warn markets that there is nothing to prevent hiking rates faster than 25 basis points per meeting. All it needs to do is remind people how quickly Chairman Volcker hiked rates in the 1980s (and then watch the market panic). Another approach would be to shift the rhetoric to become increasingly hawkish. With the current market mood, simply not being dovish is enough to push rates up. Outright hawkishness from the Chairman would get the market to push up rates even without the Fed ever doing a thing. Why not just break the promise? After all it wasn’t really a promise in the first place. Hike too early and the Fed would be like the boy who cried wolf in Aesop’s fables; its credibility would go. If the Fed were ever to find itself in this situation again (and we all hope it will not) then it would not be able to use pre-commitment as a tool to lower rates because nobody would believe it. To some market participants any form of tightening before the end of 2014, even if only at the long end, could be interpreted as a breach of promise. Current market expectations show a very gentle increase in rates even after 2014. If monetary policy turns out to be tighter then future commitments are likely to be less convincing than the last one. For the moment, at least, a need to tighten policy early is a problem that Chairman Bernanke would love to have.
Slope of the yield curve expressed as 10y yield minus effective Fed funds rate in basis points. Shaded areas denote periods when the Fed was tightening policy.
400 300 200 100 0 -100 -200 1998 1991 1994 1997 2000 2003 Curve Tightening cycle 2006 2009 2012
Source: Bloomberg, UBS Global AM
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