IMF: Premature Fed Exit Could Fuel $2.3 Trillion in Global Bond Losses

October 9, 2013, 8:59 a.m. ET

IMF: Premature Fed Exit Could Fuel $2.3 Trillion in Global Bond Losses

IAN TALLEY

WASHINGTON—A premature exit by the U.S. Federal Reserve from its easy-money policies could cause $2.3 trillion in global bond portfolio losses, the International Monetary Fund warned Wednesday. Although the IMF assumes in its latest economic forecasts that the U.S. central bank will unravel its policies at a tempered pace, the fund said the market’s volatile reaction to Fed exit comments earlier this year show there is still a risk of moving too fast.“Engineering a smooth transition to monetary normalization will require a clear and well-timed communication strategy by the Federal Reserve to minimize interest rate volatility,” said Jose Vinals, the IMF’s top financial counselor.

“Containing longer-term interest rates and market volatility has already proven to be a substantial challenge, as shown by the sharp rise in bond yields and volatility since May,” he said.

Global stock, bond and currency markets took major hits earlier this year after Fed officials indicated they could soon begin withdrawing the bank’s extraordinary stimulus, possibly before the end of this year. Markets have since calmed as the Fed tempered expectations for an earlier exit, but central-bank officials still aren’t ruling out reducing their $85-billion-a-month bond purchases before the end of the year.

Wary about higher borrowing costs choking global growth and fueling volatility, especially in emerging markets, the IMF studied how a premature exit strategy might affect markets in its latest Global Financial Stability Report.

The fund said long-term interest rates could jump one percentage point on a sharper, front-loaded winding down of Fed bond purchases than the market expected. As that rate shock traveled around the globe, it could generate “aggregate losses on global bond portfolios [worth] 5.6%, or $2.3 trillion,” the IMF said.

That figure doesn’t include other potential losses, such as in equity, real estate or currency markets.

The IMF has been a critic of the Fed’s exit strategy and communication, saying the central bank should wait until at least early next year to begin slowing its bond-buying.

Still, the fund stressed it believes a smooth portfolio rebalancing out of longer-duration, fixed-income assets on the back of a gradual rise in interest rates and repricing of credit risk is a more probable outcome.

“However, overshooting may occur as a result of any number of unanticipated events,” the fund said.

“Some fund managers may seek to adjust portfolios ahead of future monetary policy tightening to avoid crystallizing losses, thereby exacerbating market volatility,” it said.