Fed Officials Growing Wary of Market Complacency
Expectations for Rate Hikes Might Be Out of Line With Fed's
Federal Reserve officials, looking out at mostly calm financial markets, are starting to wonder whether tranquility itself is something to worry about.
So far this year the U.S. economy has suffered a brief economic contraction, the Fed has begun winding down a major bond-purchase program meant to spur growth, the Obama administration has clashed with Russia over its annexation of Crimea, China's economy has slowed and the Middle East has become a cauldron of civil strife.
Yet, looking at Wall Street stock and bond trader screens, the world looks like a model of stability. The Dow Jones Industrial Average, up a steady if unspectacular 1% since the beginning of the year, has consolidated big gains registered last year. Yields on 10-year Treasury notes have fallen even though inflation—which typically sends bond yields up—has been inching higher from very low levels.
Other measures of risk aversion and market volatility show an especially striking sense of investor calm. The VIX, which tracks expected stock-market fluctuations based on options trading, has gone 74 straight weeks below its long-run average—a run of steadiness not seen since 2006 and 2007.
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 worry at the Fed is that when investors become unafraid of risk, they start taking more of it, which could lead to trouble down the road. 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.
"This indicates a great deal of complacency," Richard Fisher, president of the Federal Reserve Bank of Dallas, said in an interview. "When you get complacency you're bound to be surprised at some point."
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 policy statement says rates aren't expected to go up much even after the Fed starts raising them. The policies are in place to invigorate a soft U.S. economy, and officials show no sign of veering from the plan.
Yet some measures suggest the market has taken the Fed's assurances further than the central bank itself.
Fed funds futures contracts traded on the Chicago Mercantile Exchange indicate investors expect the Fed's benchmark federal funds rate to average 0.6% in December 2015, up from near zero now. That's 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%.
Fed Chairwoman Janet 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. New York Fed President William Dudley warned in a question-and-answer session after a speech last month that he was nervous that unusually low volatility in markets was breeding too much risk-taking.
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.
However, 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 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. They are expected at the June meeting to keep gradually scaling back their purchases of mortgage and Treasury debt and stick to the plan to keep short-term interest rates near zero.
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 its 2% target. But, having been burned by 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?"
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."
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 and doesn't have a policy vote this year.
"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.