"Imagine that you are a bank. The Fed tells you that it is lowering short rates and holding them low for a long time. That is, in essence, a signal to borrow short and lend long.
In the summer of 2009, T-Bills were yielding roughly 0.5% and 10-year Treasuries were roughly 3.5%. If the bank were to borrow short and lend long with Treasury securities (no credit risk), it could get a spread of roughly 3%. Lever that trade up a "conservative" 10 times and you get a 30% return. 20 times leverages gets you 60% return. Pretty soon, you've made a ton of money to repair your balance sheet. The banks weren't the only ones playing this game. The hedge funds piled into this trade. Pretty soon, you saw the whole world reaching for yield. The game was to borrow short and lend either long or to lower credits. Carry trades of various flavors exploded. There were currency carry trades, some went into junk bonds, others started buying emerging market paper. You get the idea.
The net effect was that not only interest rates fell, risk premiums fell across the board. The equity risk premium compressed and the stock market soared. Credit risk premiums narrowed and the price of lower credit bonds boomed.
Managing the exit
During these successive rounds of quantitative easing, analysts started to wonder how the Fed manages to exit from its QE program and ZIRP. We all knew that the day would have to come sooner or later. So on May 22, 2013, Ben Bernanke stated publicly that the Fed was considering scaling back its QE purchases, but such a decision was data dependent.
In other words, it communicated and warned the markets! Consider this 2004 paper by Bernanke, Reinhardt and Sack called
Monetary Policy Altnernatives at the Zero Bound: An Empircal Assessment in which the authors discuss the tools that the Fed has available when interest rates are zero or near zero [emphasis added]:
Our results provide some grounds for optimism about the likely efficacy of nonstandard policies. In particular, we confirm a potentially important role for central bank communications to try to shape public expectations of future policy actions. Like Gürkaynak, Sack, and Swanson (2004), we find that the Federal Reserve's monetary policy decisions have two distinct effects on asset prices. These factors represent, respectively, (1) the unexpected change in the current setting of the federal funds rate, and (2) the change in market expectations about the trajectory of the funds rate over the next year that is not explained by the current policy action. In the United States, the second factor, in particular, appears strongly linked to Fed policy statements, probably reflecting the importance of communication by the central bank. If central bank "talk" affects policy expectations, then policymakers retain some leverage over long-term yields, even if the current policy rate
is at or near zero.
The market misses the point
From my read of market commentaries, I believe that analysts are focusing too much on the timing and mechanics of "tapering" and not on the meta-message from the Fed. If quantitative easing is meant to lower interest rates and lower the risk premium, then a withdrawal of QE reverses that process. In effect, the Fed threw several giant parties. Now it is telling the guests, "If things go as we expect, Last Call will be some time late this year."
Imagine that you are the bank in the earlier example which bought risk by borrowing short and lending long, or lending to lower credits in order to repair your balance sheet. When the Fed Chair tells you, "Last Call late this year", do you stick around for Last Call in order to make the last penny? No! The prudent course of action is to unwind your risk-on positions now. We are seeing the start of a new market regime as risk gets re-priced.
That's the message many analysts missed. The Fed is signaling that risk premiums are not going to get compressed any further. It will now be up to the markets to find the right level for risk premiums. Watch for Ben Bernanke to elaborate on those issues on Wednesday* (see note below). In the July 4 edition of
Breakfast with Dave, David Rosenberg wrote the following about the Fed's communication policy:
I actually give Bernanke full credit for giving the markets a chance to start to price that in ahead of the event, and to re-introduce the notion to the investment class that markets are a two-way bet, not a straight line up. Volatility notwithstanding, I give Berananke an A+ for shaking off the market complacency that came to dominate the market thought process of the first four months of the year (to the point where the bubbleheads on bubblevision were counting consecutive Tuesdays for Dow rallies). Ben's communication skills may be better than you think - underestimating him may be as wise as underestimating Detective Columbo, who also seems "awkward" but was far from it.
Bernanke knows exactly what he is doing when he hints about tapering in his public remarks.
It's the risk premium, stupid! And it's going up."
http://seekingalpha.com/article/1537182-it-s-the-risk-premium-stupid
http://humblestudentofthemarkets.blogspot.com/2013/07/its-risk-premium-stupid.html
http://www.theage.com.au/business/c...g-its-presence-felt-again-20130510-2jdje.html
http://www.bloomberg.com/news/2013-...ace-two-ratios-as-fdic-sets-capital-vote.html
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