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Dean Curnutt |
By Dean Curnutt
In its most recent communiqué to the markets, the Federal Open Market Committee said it expects to maintain a “highly accommodative stance” for monetary policy and that economic slack, along with well behaved inflation are likely to warrant exceptionally low interest rates through at least 2014. This bold statement—and the extent to which the market believes it—has significant implications for both risky and risk free assets. At present, market prices suggest the Fed’s policy commitments are money good. If history is any guide, however, investors will be well served to approach this “sure thing” with a healthy degree of skepticism.
The Fed argues its moves are necessary to counteract the strong deflationary forces at work in the economy. Unemployment is high and may remain so for structural reasons, consumers are awash in debt and further deleveraging appears inevitable. The housing overhang has strangled credit creation and countercyclical government deficit spending may have run its course. All told, deflationary forces are strong and must be overcome in order to satisfy the FOMC’s “full employment” mandate.
The Fed, of course, also points to low levels of inflation in justifying its vastly accommodative stance. Wage growth is muted, resource utilization is low, the Consumer Price Index is tame and market implied inflation expectations suggest little concern that price pressures will materialize in the future. The absence of inflation is important in shaping market outcomes—it is a powerful enabler of the Fed’s policy stance which in turn is creating a risk-taking framework that assumes zero percent rates in perpetuity. Investors believe they have two choices: invest in risky assets or sit on cash and earn nothing. This binary nature of financial decision-making is fraught with danger.
Ben Franklin once conjured the clever phrase, “Money makes money and the money money makes makes more money”. He was describing the power of compound interest and, hopefully, championing the virtue of saving. Ben Bernanke has turned this upside down. In today's world, storing money costs you money.
Ben Bernanke's version of Ben Franklin's old adage is not about interest, but about carry. When markets are turbulent and risk aversion is strong, investors view cash as a safe haven that shields a portfolio from volatility and loss. As the markets have recently stabilized and volatility has compressed, risk appetite has returned and investors are growing impatient with the negative carry component of holding cash. Bernanke’s objective is to convince the market that the opportunity cost of holding cash will remain so costly for so long that investors will be forced back into risky assets.
On this front, Bernanke is making a great deal of progress, but one must wonder what the ultimate consequences are. In the chart below, the expected average Fed Funds rate is shown for successive months out to two years (this is equivalent to 100 minus the Fed Funds futures contract for each month). The difference between the market’s current expectations and those that prevailed a year ago is striking. In February 2011 the market expected the Fed funds rate would be roughly 1.75% in two years. Fast forward a year and, with the SPX and VIX at roughly the same levels as last year, the market expects the Fed funds rate in 2013 will be just 33bps in two years!
This chart makes clear the extent to which the force of the Fed’s “low forever” language has been fully priced into the market. As noted, there remain strong economic headwinds, and the zero percent path of interest rates may turn out to be so. But has the market priced in enough margin for error? Recent financial history illustrates the danger of extrapolation and the risk that investors overprice certainty. Recall that during the real estate bubble, it was abundant and cheap credit that fueled housing price appreciation and further perpetuated speculative buying and lending. The price of insurance—an ultra low VIX, negligible corporate credit spreads, and mortgages based on no documentation—became fundamentally divorced from the reality of risk in the marketplace. The unwinding of this mispricing was catastrophic.
With present day inflation low and the consequences of deflation so unappealing, Bernanke appears ready to stay the course, and he’s convinced the market as much. But to the extent the economy continues to improve and corporate profits remain robust, the opportunity cost of holding cash may force investors to capitulate and shed “risk free” assets in favor of those that earn something. If this coincides with firmer readings on inflation and employment, one must wonder if the Fed can remain committed to anchoring rates at zero and, moreover, keep the market convinced it will do so well into the future. The market may price a future outcome with a level of certainty that the Fed cannot reasonably guarantee. There is money to be made and lost as a result.
Dean Curnutt is president of Macro Risk Advisors LLC, an equity derivatives strategy and execution firm which specializes in translating proprietary market intelligence into actionable trade ideas for institutional clients. The New York-based firm is a registered broker/dealer with the FINRA.