On Monday evening, we brought you “Dude, Relax: Stanley Fischer Doesn’t See Any Risk Of Another Taper Tantrum.”
We knew no one was in the mood to talk about Fed balance sheet normalization coming off a long holiday weekend, but we ran the post anyway because it was, frankly, important.
Despite Fischer’s contention that the debate about portfolio run off has been “limited,” there’s actually been no shortage of discussion about what tightening-by-balance-sheet would mean versus tightening by FF hike. The now ubiquitous nature of that debate made Fischer’s speech something worth noting.
Additionally, his assurances that talk of balance sheet shrinkage won’t be met with a taper tantrum redux probably fell on deaf ears because, well, the bond market hasn’t exactly looked like it’s in the mood to sell off recently. Indeed if there’s a risk to equities from Treasury yields now, it’s that a continuation of the recent trend lower completely obliterates the reflation narrative leaving everyone who’s bought stocks based on that narrative holding a rather unpleasant smelling bag. That as opposed to 10Y yields suddenly spiking above 3%, flipping the stock/bond return correlation positive in a tantrum redux.
Simply put, there was a lot to talk about in Fischer’s generally overlooked comments.
Well Bloomberg’s Cameron Crise took note and below, find some great commentary on everything said above, the juxtaposition in spec positioning going into the recent rally versus what things looked like going into the tantrum, and a whole hell of a lot more.
Monday night, Stanley Fischer made the case that ending the Fed’s reinvestment policy should only have a modest impact upon bond yields. While I largely agree with his conclusions, I think that the Fed vice chairman missed a couple of important points.
- In contrasting the 2013 taper tantrum with the recent reaction to Fed discussions about ending its reinvestment policy, Fischer focused on market expectations. He correctly noted that simply observing the median expectation of a narrow range of actors can miss an important distinction. There is a big difference between a few non-consensus forecasts held with high conviction and a broad range of expectations held with relatively little confidence.
- However, the focus on surveyed expectations misses the most important manifestation of market belief: positioning. In the prelude to the taper tantrum, the speculative market was long U.S. fixed income across the Treasury and eurodollar curves to the tune of nearly $40 million per basis point move. Going into what has become the “reinvestment rip,” the spec market was short with a DV01 of more than $120 million per basis point, according to CFTC data and Bloomberg calculations.
- In each case, there has been a consistent outcome: the speculative market position has lost money. I would suggest that the losses this time around have been more modest because a) the policy in question is ostensibly supportive of the market position, and b) the actual impact of the policy in question would be more muted on a tradeable horizon.
- Fischer also noted that “it is hard to argue that predictability in our reaction to economic data could be anything but positive.” I would disagree; becoming too predictable can breed financial market complacency.
- I created a measure of monetary policy uncertainty, which is essentially a rolling standard deviation of the difference between the two-year note and the Fed funds rate. Unsurprisingly, this measure tends to rise when the Fed is engaged in an interest rate hiking/cutting cycle.
- The one exception to this pattern of behavior over the past several decades was the 2004-2006 tightening cycle, which was telegraphed and executed with unprecedented clarity. During this period, the policy uncertainty index drifted sideways to lower at what was then record low levels.
- At the same time, market volatility collapsed and leverage soared. This in turn, laid the foundation for the financial crisis of 2007-09. It’s hard to argue that that was a good outcome for either the economy or the Fed.
- Ironically, the last Fed tightening cycle that engendered significant bond market volatility (1994-95) was also the last one that was not followed by a recession within a couple of years.
- The Fed has trained the market to expect explicit guidance on policy actions, particularly tightenings. While the FOMC shouldn’t wrong-foot the financial markets just for the sake of it, by the same token, keeping them guessing a bit more could raise market risk premia — and perhaps reduce the chance of another crisis.