The Fed was worried the stock market was too calm. No longer.
The past two weeks’ wild fluctuations in the stock and bond markets have vindicated the warnings from Janet Yellen and other Federal Reserve officials that investors might be overly sanguine about the central bank’s plans for interest rates.
Volatility was near record-low levels throughout the summer and into October as the Fed methodically carried out the “taper” of its monthly bond purchases, which are expected to end at the Fed’s Oct. 29 meeting.
But things went awry in the past two weeks, as the S&P 500 dropped by more than 7 percent from its record high in late September and volatility spiked. Meanwhile, yields on mortgages and government bonds plummeted, with yields on 10-year Treasury notes dropping from 2.5 percent to below 2 percent, the lowest rates since the “taper tantrum” that followed the Fed’s announcement in summer 2013 that it would cut back the quantitative easing program.
Fears about the possibility of a recession in Europe, disappointing U.S. retail sales and the threat posed by the Ebola virus all may have played into market swings. But Fed communications regarding plans to raise short-term interest rates from zero for the first time since 2008 also have played a role.
“Part of this major move we had this week was caused by the Fed,” said Brian Edmonds, the head of interest rates trading at Cantor Fitzgerald & Co. “I think in their quest for transparency there were some problems in the communication, and I certainly think that had an impact on what happened this week,” Edmonds said, referring to the minutes from the Fed’s September meeting, which were interpreted as suggesting that Fed officials were planning to keep rates lower than the official statement from that meeting had indicated.
Yellen had warned as early as June that low volatility might reflect overconfidence in the Fed’s plans for rate increases. The Fed “has no target for what the right level of volatility should be,” the central bank’s chairwoman said at a press conference, “but to the extent that low levels of volatility may induce risk-taking behavior … that is a concern to me and to the committee.” She added that “it is important … for market participants to recognize that there is uncertainty about what the path of interest rates — short-term rates — will be.”
Those concerns were echoed by other Fed officials. Boston Fed President Eric Rosengren warned during a visit to the Central Bank of Guatemala in June that “this relative calm may be challenged in the future” and explained that “uncertainty or misunderstanding about the contours of our exit has the potential to be problematic.”
Now, with markets upset, there is confusion about what the Fed’s next steps will be.
Market expectations of when the first rate increase will come have fluctuated, and now bond markets suggest that the first hike isn’t expected until next fall.
The market turmoil may even call for the Fed to put off or even ramp up its bond purchases, St. Louis Fed President James Bullard suggested Thursday. “We could go on pause on the taper at this juncture and wait until we see how the data shakes out into December,” Bullard said in an interview on Bloomberg Television. “If the market is right, and this is portending something more serious for the U.S. economy, then the committee would have an option of ramping up QE at that point,” Bullard said.
Philadelphia Fed President Charles Plosser disagreed, however, saying after a speech in Allentown, Pa., Thursday that “it is a mistake for either the public or the Fed to think we are responsible for movements in the stock market,” according to the Wall Street Journal.
For her part, Yellen appears to be taking the market movements in stride. Bloomberg reported Wednesday that she voiced confidence in the underlying strength of the economy over the weekend in a meeting with bankers and academics despite the financial market turmoil.
One reason for confidence at the Fed may be that, unlike last year’s spike in bond yields following the talk of ending the Fed’s bond purchases, this week’s jitters have seen bond rates fall.
“After all, the objective of quantitative easing policies is in substantial part to bring down long-term interest rates, and the 10-year Treasury has moved from about 3 percent at the beginning of the year to about 2 percent today, and that’s going to over time translate into mortgage relief for homeowners,” Harvard professor and former Obama and Clinton economic adviser Larry Summers said Thursday in an interview with National Public Radio. In fact, 30-year mortgage rates dropped to 3.97 this week, the lowest level since June 2013.
Edmonds said markets are not headed for a crisis, but that the Fed would have to better communicate its intentions to avoid further market volatility. “It’s been an experiment,” he said. “I know they’re trying to figure out what the proper mix of transparency is, but I don’t think they’ve quite figured it out yet.”
