Fed Officials Growing Wary of Market Complacency; Expectations for Rate Hikes Might Be Out of Line With Fed’s

Fed Officials Growing Wary of Market Complacency

Expectations for Rate Hikes Might Be Out of Line With Fed’s

JON HILSENRATH

Updated June 3, 2014 7:30 p.m. ET

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 the height of the financial crisis in 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. It could come up again when officials meet in mid-June.

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.”

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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.

 

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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