Yellen Warns on Market Calm Before ‘Considerable Time’ Up

Federal Reserve Chair Janet Yellen says she wants investors to be prepared for the possibility that the Fed will raise interest rates sooner than they currently project. Her words are going unheeded.

Volatility across stocks, bonds and currencies worldwide is close to record or multi-year lows, even after Yellen cautioned last week that the Fed’s commitment to keep interest rates near zero for a “considerable time” could change if U.S. economic performance continues to exceed expectations.

This absence of wide swings in trading values reflects investor complacency about the central bank’s intentions — and may be too much of a good thing for its policy makers as they consider retreating from years of low-rate pledges that suppressed borrowing costs and fueled a recovery from the worst recession since the Great Depression.

The danger: unexpected economic strength may speed up the timetable for tighter Fed policy, prompting a sudden surge in volatility that could jeopardize the expansion.

“The risk is that the Fed ultimately does tighten policy in the way that it’s expecting and is communicating, and markets have to adjust up very quickly in a disorderly way,” said Laura Rosner, a U.S. economist at BNP Paribas SA in New York and a former New York Fed researcher.
Bank of America’s MOVE Index of Treasury swings fell to 57.43 yesterday, close to its lowest level in data since 1988. The Chicago Board Options Exchange Volatility Index, which measures swings in stocks, was at 14.93, compared with a 20-year average of 20.75. The JPMorgan Global FX Volatility Index was at 7.38 percent, still near a record low of 5.29 percent in July and down from a 20-year average of 10.46 percent.
‘Considerable Time’

Contributing to the markets’ quiescence is the Fed’s decision at last week’s meeting to retain assurances that the benchmark interest rate will stay low for a “considerable time” after the central bank ends a bond-purchase program intended to spur growth. And once the rate is raised, investors are projecting a slower pace of increases than the Fed itself.

Fed officials began to rely on forward guidance to keep yields low in short-term debt maturities after cutting the federal funds rate almost to zero in December 2008. Bond purchases, which have pushed down long-term yields, were another easing tool.

Now, with unemployment down to 6.1 percent from a 26-year high of 10 percent in 2009, the Fed is planning to end bond purchases after its October meeting. The Fed’s estimate for full employment, one of its policy goals, is 5.2 percent to 5.5 percent.
First Increase

Officials, who project the fed funds rate will rise next year for the first time since 2006, are debating a change to their forward guidance. The rate represents the cost of overnight loans in the interbank market.

While policy makers retained the language this month, Yellen used her post-meeting press conference to assert that the Fed’s guidance depends on how the economy evolves.

“It is important for markets to understand that there is uncertainty and that the statement is not some sort of firm promise about a particular amount of time,” Yellen said.

If economic performance trails expectations, rates will stay low for longer, she said. If it’s better than forecast, rates could rise more quickly.

Other officials have reinforced that message.

St. Louis Fed President James Bullard said yesterday that the Fed may need to drop its pledge next month.

“I don’t think it is state-contingent enough,” said Bullard, who will have a vote on policy in 2016. “I would like to get the committee to move to something that is more data dependent.”
Policy Bellwether

Bullard is seen as a bellwether because his views have sometimes foreshadowed policy changes. He published a paper in 2010 entitled “Seven Faces of the Peril,” which called on the central bank to avert deflation by purchasing Treasury notes. That was followed by a second round of Fed bond buying.

Yellen wants to retain flexibility and react to gyrations in economic data after a 2.1 percent contraction in the first quarter gave way to a 4.2 percent jump in the following three months, said former Fed Governor Randall Kroszner.

“They’re not sure how the economy is going to evolve,” Kroszner, who teaches economics at the University of Chicago, told ForexSQ Radio on Sept. 19. “It really is about the data.”
Investor Expectations

Market calm is being supported in part by investor expectations that the path of interest-rate increases is likely to be shallower than the Fed itself projects.

Federal funds futures expiring in December 2015 trade at 0.74 percent, compared with Fed officials’ median projection of 1.375 percent for the end of that year in forecasts issued Sept. 17. The divergence is even wider for the end of 2016, when futures traders see a federal funds rate of 1.8 percent, while Fed estimates call for an increase to 2.875 percent.

The divergence shows “the public might not give enough weight to how dependent the central bank’s guidance is on both current and incoming data,” researchers at the San Francisco Fed wrote in a Sept. 8 report.

Some officials at the June Fed meeting said they viewed low volatility, as well as signs of increased risk-taking, as indications investors weren’t “factoring in sufficient uncertainty about the path of the economy and monetary policy,” according to minutes of the gathering.
Getting Message

Still, Treasuries are starting to react more to better-than-expected economic data, showing that investors are starting to get the message, according to Eric Green, head of U.S. rates and economic research at TD Securities USA LLC in New York.

“The correlations are rising, and the response of the market to the data is increasing,” Green said, citing research by his team showing bigger moves in securities tied to rates. “Markets aren’t as far away from what the Fed’s telling them.”

Central bank officials may have created a dilemma for themselves similar to one they faced in May 2013, when then-Chairman Ben S. Bernanke suggested that the Fed’s asset purchases could end sooner than expected, said Kathleen Bostjancic, a financial-market economist at Oxford Economics in New York.

Bernanke’s comments caused a more than one percentage-point jump in 10-year Treasury yields in a move dubbed the “taper tantrum.” A repeat of that surge may erode economic growth and cause a 10 percent decline in U.S. stocks, Bostjancic said. To prevent such a reaction, the Fed should start preparing markets with more hawkish language sooner rather than later.

“They’re overly fearful about an adverse reaction in the bond market, so they’re using this excessive guidance, and the longer they use it, the harder it gets to change it,” Bostjancic said. “Low volatility amplifies the risk greatly and the chances you have some turbulent reaction.”

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