When it comes to central banks, I learned a long time ago to trust their actions rather than their words. The Federal Reserve begins their regular monthly meeting today, which will be followed by the announcement of the rate decision and the subsequent press conference. Both the announcement and the decision will most likely be couched in words that we have become familiar with. “Steady recovery,” “Gradual reduction in asset purchases” and my personal favorite, “Extended period,” will all no doubt make another appearance.
All of these things suggest that any move away from the extraordinarily easy money policies of the last few years is a long way off. If this FT report is to be believed, however, we would be wrong to assume that that means that rate hikes are too far away and too remote a possibility to be considered. For the Fed, however, just considering them creates a “Catch-22”-like problem.
The report maintains that the Fed has discussed the possibility of exit fees for bond funds. This may seem like a somewhat trivial administrative matter, and one that it is only logical to consider. The concern is that bond funds in general have become like a shadow banking system, offering a return on money with the right to withdraw the funds at any time. This complete liquidity for the investor, however, is based on assets that have become increasingly illiquid.
Large banks are nowhere near as active in the bond markets as they were a few years ago. Tougher capital regulations and the scaling down of fixed income trading operations have resulted in Wall Street banks stepping back from their role as providers of massive liquidity to the bond market. The mutual funds, if faced with large scale redemptions, may have trouble finding buyers for large blocks of corporate bonds. In that situation it would seem to be only prudent for the Fed to consider some kind of protection for the funds. The question that many are asking, however, is why now?
I will be listening to the conference tomorrow, curious as to the response if this is brought up, but that response is unlikely to tell us much. I am sure that Yellen will tell us that the discussions were preliminary and only prudent; that they have no significance, that the Fed is all too aware that, at some point, rates must “normalize” and that this issue is a boring, technical piece of administration. What else could she say? Any hint that the Fed perceives a potential disaster scenario in the event of a bond selloff would simply cause that selloff.
This is precisely why I prefer to watch the actions of central banks rather than listen to their words. Central bankers have known for a long time that what they say about what they might do is in many ways more important than what they actually do. If you doubt me, take a look at the effect on the S&P 500 in the week or so after the talk about tapering (first gold line) and the actuality (second gold line).
It is clear that talk about tapering was far scarier than the actual reduction in asset purchases. Armed with the knowledge that this is the case, the words of central bankers around the world are tailored to produce a desired reaction.
In this case talk about offering some protection to bond funds is one thing, but if the Fed actually goes ahead with any plan that they may have formulated from those discussions, then look out below! No matter how much they may protest that such a measure is just a sensible precaution, the market would, I’m sure interpret it as a sign of an imminent interest rate rise.
This is the “Catch-22” that Yellen and the Fed face. If they do what they believe is required to protect against panic selling of bonds they could well cause just that to happen, along with a serious correction in stocks. If they talk about it, they could cause it to happen before the needed protection is in place.
Of course, all of this is speculation based on one unconfirmed report of discussions that would have been by nature preliminary if they took place. That said, though, it should be borne in mind that if exit fees on bond funds are introduced, the Fed is all too aware that it would have to be presented as a fait accompli. We cannot expect much public discussion of exit fees. That is why, even though it may seem to some to be an overreaction to a slight possibility, reducing your exposure to bonds now may be a smart thing to do.