New York: The Federal Reserve has been holding the hand of the world’s biggest debt market far too tightly.
So laments Morgan Stanley head of global interest-rate strategy Matthew Hornbach after a week in which a bevy of Fed officials telegraphed a March interest-rate hike, with the exclamation mark coming Friday from chair Janet Yellen. So swift was the turnaround, that market-implied odds of a hike this month moved from less than 50% to a virtual certainty in the space of five days.
“For the third time this cycle, the Fed effectively hiked rates before gathering to discuss the possibility,” Hornbach wrote in a 3 March note. “As long as the Fed pre-signals rate moves, the bond market will never react to ‘data’ -- both economic and market data -- in the way the Fed intends -- i.e., the Treasury market will be constrained in the manner in which it responds to the financial conditions process.”
For the Fed, rate hikes are a means to an end: smoothing the business cycle. The Treasury market plays an important role in that regard. Changes in borrowing costs based on the market’s estimate of the central bank’s policy path can dampen real economic activity going forward and prevent pricing pressures from getting too hot.
But that process has effectively been short-circuited by far-too-effective forward guidance, argues Hornbach. The Treasury market can afford to take its cue from monetary policymakers rather than weighing economic data, fluctuations in financial markets, and likely policy outlook and arriving at the same conclusion independently.
“If the Fed had adopted this hands-off modus operandi earlier -- which would not have been appropriate ahead of lift-off, in our view, but is more appropriate now -- we think the Treasury market would have already placed an 80 percent probability on a March rate hike,” writes Hornbach. “Investors need to start setting their expectations differently, we think, and the Fed needs to lead the way sooner rather than later.”
With investors conditioned to take their cues from the Fed, Treasury yields will “remain subdued” and equity prices will continue on their upward trajectory through the end of the month, the strategist said.
Morgan Stanley’s critique is reminiscent of a previous paper by Tobias Adrian and Hyun Song Shin. Back in 2008, the academics warned that providing markets with too much certainty on the path for interest rates risks laying the foundation for a buildup of financial excesses.
“If central bank communication compresses the uncertainty around the path of future short rates, the risk of taking on long-lived assets financed by short-term debt is compressed,” they wrote. “If the compression increases the potential for a disorderly unwinding later in the expansion phase of the cycle, then such compression of volatility may not be desirable for stabilization of real activity. In this sense, there is the possibility that forward-looking communication can be counterproductive.” Bloomberg