Tim Duy had an interesting comment about the bind that the Fed finds itself in today:
Confusion arises when one realizes the Fed does not intent to use all of its available tools to meet its goals. In particular, there is no inclination to expand the pace of asset purchases, and is instead every inclination to end the program. They are looking forward to normalizing policy by shifting the focus to forward guidance on interest rates.
In other words, they would like to taper and stop expanding the Fed's balance sheet. They believe that forward guidance is another tool that they can use instead of QE:
Bottom Line: Policymakers would like to normalize policy by moving away from asset purchases to interest rates. Emphasizing forward guidance is part of that process. Incoming research suggests not only that threshold based forward guidance is effective, but has room to be even more effective. That should be a comfort to policymakers who worry that ending asset purchases will excessively tighten financial conditions; they have a tool to change the mix of policy while leaving the level of accommodation unchanged. Whether they use it or not is another question. There has clearly been some discomfort among policymakers regarding changing the unemployment threshold. This suggests it would not necessarily be an immediate replacement for ending asset purchases. That said, it is difficult to see how the current threshold is meaningful at all if the Fed is still purchasing assets when the threshold is breached. Indeed, the current low level of unemployment relative to the threshold, combined with clear indications that the Fed has no intention of raising rates anytime soon, argues by itself that a change in the thresholds is a likely scenario in the months ahead.
How to taper without tapering?
There has been a lot written about quantitative easing. Does it work? Is it as effective as it could be? Recent analysis by prominent policy makers and analysts suggest otherwise. Larry Summers' IMF speech indicated that the world is stuck in an era of stagnation and serial central bank bubble and Ray Dalio of Bridgewater believed that QE is running out of gas. The episode in the May-September period demonstrated how the market perceived QE, which seemed to have caught policy makers by surprise.
I argued before that the main effect of QE is risk premium compression, which produces a wealth effect (see It's the risk premium, stupid!)..By pushing down Treasury yields and mortgage rates with asset purchases, the Fed forced investors to take more risk, which, by definition, QE forces down the risk premium. When the Fed signals that it is about to taper, risk premiums rose. Why is that market response such a surprise to the Fed?
The greatest risk from the recent rise in risk premiums came from emerging markets. Cullen Roche at Pragmatic Capitalism highlighted a SocGen report of the effects of tapering on EM sovereign funding costs:
Fed policy, a sword of Damocles for emerging markets
Following the Fed's decision in September to postpone tapering, emerging markets (EM) rebounded strongly. But this relief rally has now stalled, as investors are cautious about the central bank's next move (see chart). Indeed the latest FOMC meeting confirmed the Fed's bias for tapering and the very good employment report released last Friday reinforces our economists' expectation of a March 2014 taper. The threat of rising global yields is a key downside risk for EM assets near term. Higher bond yields should trigger portfolio rebalancing and the "repricing of risk could spark a run by investors holding speculative positions", says the IMF. The shock will be further amplified in countries with external imbalances and vulnerable financial systems.
Indeed, the relative performance of emerging market bonds (NYSEARCA:EMB) against U.S. junk bonds (NYSEARCA:HYG), as a measure of "junk" against "junk", that the relative performance of EM bonds have stabilized against U.S. high yield, but there has been no relative recovery yet. Technicians will note that this pair violated a multi-year relative support level but rally attempts have failed at a key support-turned-resistance.
In effect, any rise in risk premiums from Fed tapering has the potential to cause an emerging market crisis, whose contagion effects could spill over and threaten the stability of the global financial system. Even though Fed officials stated at Jackson Hole that they are not responsible for EM economies (see this Bloomberg report), the market selloff in the wake of the May 22 hints that tapering might have been a concern to a Federal Reserve concerned with financial stability and systemic risks.
For central banker policy makers, the May-September episode presents a Zen-like problem, especially for FOMC members who are concerned about the expansion of the Fed's balance sheet: "How do you taper, but avoid the market effects of tapering?"
The Fed giveth and the Fed taketh away
John Hilsenrath penned an article last week that explained the likely way forward for the Fed. It could begin to taper, but present forward guidance that signals greater accommodation than what the market expects:
One idea under discussion is to lower that unemployment threshold from 6.5%, which could mean keeping rates down longer. Fed staff research suggests the economy and job market might grow faster, without much additional risk of inflation, if the Fed promised to keep rates near zero until the unemployment rate gets as low as 5.5%. Goldman Sachs economists predict the Fed will lower the threshold to 6% as early as December and reduce the bond-buying program at the same time.
Could that form of forward guidance serve to hold down the risk premium while the Fed reduces the rate of growth of its balance sheet? My gut reaction is no - that risk premiums would rise, largely because that form of guidance only serves to hold down interest rates and does little to directly affect the risk premium between mortgage rates and Treasury yields. But then, I have been wrong before.
Central bankers are truly sailing in uncharted waters. The Fed has discovered the non-linear effects of adaptive expectations. I am closely watching emerging market currencies and bonds for the real market reaction should the Fed adopt such a course of action.
Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui's blog to ensure it is connected with Mr. Hui's obligation to deal fairly, honestly and in good faith with the blog's readers."
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