Switching: Ben Bernanke thinks the move to threshold-based guidance will 'allow markets to respond quickly.'

Fed's course could make for an interesting 2013

Changing triggers raises concerns over more volatility in bond markets

Institutional fixed-income money managers generally welcomed the Federal Reserve's earlier-than-expected decision in December to tie interest rates to specific economic indicators, with some concern for the possibility of greater volatility.

Concluding their last 2012 Federal Open Market Committee meeting on Dec. 12, Federal Reserve officials committed to further bond purchases and to keeping the federal funds rate within a zero to 0.25% target range “at least as long as the unemployment rate remains above 6.5%.” The shift from calendar-based guidance that had rates staying at zero to 0.25% through 2015, to specific thresholds such as a change in unemployment, “is a better form of communication,” Chairman Ben Bernanke said at a news conference.

“The date-based guidance served a purpose, but was not a transparent process,” he said, whereas with threshold-based guidance, “the markets and business community can make the adjustment on their own. It will allow the markets to respond quickly.”

But that response to certain economic indicators, like a change in the unemployment rate, as a trigger for interest rate changes can also create a greater risk that investors will react to more volatile data points, and in the process create more market disruption than the economy as a whole might warrant. In recent years, unemployment rates, for example, moved up for a few months, and then sat unchanged for six months, even though other economic indicators improved.

“As the economic data come out now, the market is going extrapolate those short-term fluctuations. It could create opportunities, but there is a possible impact as well,” said Robert Tipp, Newark, N.J.-based managing director and chief investment strategist at Prudential Fixed Income, which ran $356 billion as of Sept. 30. “If they come out with hard criteria, that will inject a lot of volatility into the market.”

John Bellows, investment management strategy analyst with Western Asset Management in Pasadena, Calif., which runs $459.7 billion, is not concerned. “Volatility could increase, but perhaps not by as much as some fear. The Fed went out of its way to say that these aren't hard targets. I think the Fed is going to try very hard to preserve flexibility and they won't respond to any one data release. They are not obligated to act” if the unemployment rate drops below 6.5%.

“They are definitely not targets,” agreed Joshua Feinman, New York-based managing director and chief global economist for Deutsche Bank Asset Management in the Americas, which managed $26.3 billion in fixed income as of Dec. 31, 2011. “They are thresholds for the Fed to begin considering changing the funds rate. They want to give themselves wiggle room to respond. No single variable can capture all the complexities and nuances of the U.S. economy. They have to lift up the hood and see what's really going on.”

Willing to continue

This year has seen several rounds of quantitative easing, keeping interest rates low and buying longer-term Treasuries and mortgage-backed securities. The Fed also has extended the Operation Twist program begun in 2011, selling shorter securities and buying some $45 billion longer-term ones each month. That program, which has nearly run out of short-term securities to sell, ends this year, but “the Fed has already hinted that they were prepared to keep going on the purchase side,” said Jeffrey Rosenberg, chief investment strategist for fixed income at BlackRock (BLK) Inc. (BLK), New York, which had $1.2 trillion in fixed income as of Sept. 30.

To appease some of the more hawkish committee members who want to try different tactics, Federal Reserve officials in October asked a committee to explore defining hard targets that would justify changes in monetary policy. At the top of the target list was any change in unemployment rate, followed by signs of inflation, or growth in the gross domestic product.

“There has been a very healthy debate about the strengths and weaknesses” of targets, said Brian Kinney, global head of fixed-income beta solutions at Boston-based State Street Global Advisors, which has a total of $2.1 trillion under management.But specific targets also raise a big question of what happens to the market when they are hit — or missed.

“It would be good for money managers, but not for plan sponsors,” said Mr. Tipp of Prudential. “The fact of the matter is that it's extremely difficult to forecast economies. What happens is, you get surprised.”

While plan sponsors would suffer less predictability and more volatility, as markets react to changes in specific criteria, “For money managers it creates a lot of opportunities,” said Mr. Tipp. “You may be able to countertrade the excess volatility. If you're good at figuring out underlying trends, it will create opportunities.”

When you (go from) calendar to thresholds, our job is to price and figure out what it means, and now there is a lot more uncertainty as to where along the curve do we price those. It certainly creates a pricing dynamic,” said BlackRock's Mr. Rosenberg.

“It's very clear that because the Fed is doing what it's doing, there are very low expectations for risk budgeting in fixed income,” Mr. Rosenberg added. ”Interest rate volatility is very low, so compensation is very low. So we sell credit risk, liquidity risk, housing policy risk. These are areas where we see less risk developing and good compensation for managing that risk.“

Difficult switch

Mr. Feinman of DeAM, a former Federal Reserve economist, cautions that switching to specific outcomes from calendar-based scenarios is no simple matter. “There are a lot of technical difficulties to sort out. ... The trade-off on all these things is flexibility vs. clarity.”

“Whenever there is a change of regime, the market has to adjust,” agreed Mr. Tipp. If rates are tied to specific target indicators, “my concern is that the constraints of economic criteria are going to be too close to where we are in terms of economic statistics, and the market is going to extrapolate every wiggle in data, and react each time. I think that will be jangling for investors.”

One consensus among bond managers is that investors and money managers should be prepared for anything. “The Fed's been trying out a lot of new things. They have been pushed into uncharted territory,” said Mr. Feinman. Still, he added, “I'm starting to sense that the outlook is getting brighter, or could be brighter. The headwinds that have been holding the economy back seem to be going away.

“There is certainly no need to even think about taking away the (low rate) accommodation. Ultimately they have to shift gears, but that's a much better set of problems.”

Mr. Bellows of Western Asset Management agreed. “The Fed has been very aggressive over the last four years, and remains in an aggressive easing stance,” he said. “Yields could increase if the growth outlook improves, but we don't expect them to fully normalize in the coming year. We know the Fed will continue to be easing in 2013, and that will exert downward pressure on yields.”

This article originally appeared in the December 24, 2012 print issue as, "Fed's course could make for an interesting 2013".