Outgoing Federal Reserve Chairmen Ben Bernanke recently said that, at present, the Fed is not overly concerned with the danger of bubbles forming in the financial system, although he stressed that the Fed is “watching vigilantly” for such risks. Based on the Federal Reserve’s track record, surely there would be no bubbles if they truly had such foresight.
Soon we will forget the credit crisis and the housing market debacle. What will be the next shoe to drop? Cynics may suggest that Bernanke can afford not to be concerned with bubbles forming in the markets, because in a few weeks’ time, it will no longer be his chief concern. Broadly speaking, market valuations appear to fall within historical ranges as matters stand right now, however that should not be viewed as comforting, in and of itself. Perhaps most worryingly, at present, we are quick to fabricate reasons for bad numbers coming out. For instance, adverse weather was blamed for the December 2013 non-farm payrolls hitting a three-year low, really? In our eyes, it is the Fed’s bond buying program that poses the greatest threat to the economy and the inherent risks of financial instability that it brings with it. Too big to fail comes to mind. So let’s examine where we are and where we are headed.
The Fed has been holding short-term interest rates near zero since late 2008, and at the same time, it has been buying long-term bonds to lower borrowing costs, with the aim of boosting growth and lowering unemployment. Interestingly, deflation has been a bigger concern than inflation as a result – but will this continue in the quarters and years to come?
At its December 2013 meeting, the Federal Open Markets Committee (FOMC) decided to begin tapering its bond buying program. However, the Fed made clear that it remains committed to keeping short-term interest rates near zero so long as unemployment figures remain above 6.5% and inflation is well contained, and perhaps beyond that. A poll of economists recently indicated that more than two thirds do not foresee a change in Fed policy, even with Yellen at the helm.
When the Fed finally did embark on its much talked about tapering process, it did so with a $10 Billion reduction in monthly bond purchases, down from $85 billion. Expectations are that they will continue this trend with a further $10 billion reduction announced at each forthcoming meeting, bringing the process to an end in the last quarter of 2014. Note also that the Fed spent the better part of last fall trying to convince market participants that the “tapering process” is not “tightening.”
Hopefully, at this point, there remains little confusion about the difference between “tapering” and “tightening.” “Tapering” simply means reducing the amount of bond purchases made by the Fed, as started during QE3 in an attempt to keep long-term interest rates low. In contrast, “tightening” refers to increasing the Federal Funds rate, which is the target interest rate banks charge each other to borrow funds overnight. The concepts described above quite clearly differ from one another. While tapering is already under way, tightening will follow suit soon, likely next year. The Fed made a point of stressing that they will be accommodative for a long time. According to the Fed’s own forecasts, actual tightening is projected to begin mid-2015. And the Fed will remain accommodative until the Fed Funds Rate has reached a level of 2%. Of course, being accommodative also means ongoing reflection on the true state of the economy, making Fed action highly “data-dependent”.
We believe that with Bernanke handing the Fed Chairmanship to Yellen, the dynamics of the Fed are about to change to a great extent than what is currently priced into the markets. Bernanke’s eight years will be studied and written about for years to come. Bernanke began his career at the Fed being already known as an accomplished academic and an expert on The Great Depression, knowing full well that his expertise would be tested. The financial crisis hit hard in 2008, and Bernanke proved himself under pressure as he implemented unconventional plans to inject stimulus and stabilize the economy: under his leadership, the Fed lowered rates until they could not be lowered anymore, bailed out banks, created international swap lines, committed trillions of dollars to large-scale asset purchases and engaged, how can we forget, in “Operation Twist”. From the very start, Bernanke also made a commitment to increasing transparency, so that the markets could more fully understand and appreciate the Fed’s intentions and actions. To achieve this, Bernanke did not shy away from unconventional methods: he went so far as to go on 60 Minutes to explain the Fed’s role to the general public. All of this proved very helpful in providing the markets with much-needed confidence during the crisis. As is the case with many who have made tough decisions in high-profile positions, it will be many years before we can truly understand the wider effects of Bernanke’s policies.
Yellen takes over at the upcoming January 28-29 FOMC meeting, and by all accounts the transition is expected to be smooth. Yellen has a long track record at the Federal Reserve. She has been President of the San Francisco Fed since 2004, and her ties to the Fed go back all the way to 1977. Throughout the most recent crisis, she and Bernanke have worked together very closely, with Yellen voting along with Bernanke at all meetings.
Generally, the Fed has a dual mandate: to promote maximum employment and keep a handle on inflation. Yellen herself has dedicated many speeches to the topic of employment. She has also always been very supportive of Bernanke’s push for increased transparency at the Fed, so we expect that trend to continue.
With Richard Fisher from Dallas and Charles Plosser of Philadelphia, the Fed has equipped a couple of vocal hawks with voting rights. However, President Obama’s recent nominations, including Stanley Fisher (Vice Chairman), along with Lael Brainard and Jerome Powell are believed to be doves.
The Federal Funds Target Rate (white line) has been pegged at 0.25% for the past five years. The 10-year note yield has also been steadily declining (pink line), reaching a low of 1.379% in July 2012. As the Fed began to hint at the possibility of tapering, the 10-year note yield reacted and began to rise in the spring of 2013. Ultimately, the pace of our ongoing economic recovery will dictate how soon the Fed will actually begin to raise rates. But, as mentioned before, based on the Fed’s own forecasts, tightening is expected to start in mid-2015.
Given this expectation, a good way to play this would be through the use of a spread, shorting the further out Eurodollar interest rate, March 2017, and going long the nearer-term March 2015 Eurodollar (see chart below).
Spread Chart: Long March 15’ Eurodollar/Short March 17’ Eurodollar
The long leg will serve as a safety net on a rally in nearby futures if yields actually drop. The current spread is near 2.00 full points and as rates start to move higher, we expect to see this spread trade near 3.00, which would represent a gain of $2,500. There is strong support at 1.60, which is where we would place our stop, so this position would have a 2:1 risk/reward ratio.