Twas the night before the September Fed meeting, when all through the house

Not a computer was stirring, not even its mouse;

The sell tickets were stacked throughout the trade floor with care,
In fret that Ben “Scrooge” Bernanke soon would be there.

Then on the wires there arose a surprise clatter,
The Fed said “no taper” – it wants to make wallets fatter!

Into the dustbin went the red tickets in a flash,
Today there is joy – the Fed’s printing cash!

In May, Federal Reserve Chairman Ben Bernanke surprised many investors when he hinted that the Fed might reduce its monthly bond buying. His words sent the markets into turmoil, in particular the global bond market, sending one of the strongest messages of 2013 to the Fed and markets.

What the Fed hoped would happen didn’t. It hoped that its cumulative bond buying would keep interest rates stable even if it hinted at a reduction in monthly purchases. In other words, the Fed expected the stock effect of its purchases to be more potent than the flow effect. This makes intuitive sense, after all. Why should a reduction of, say, $10 billion out of $85 billion in monthly purchases upset the bond market when the Fed had already bought trillions of dollars’ worth of bonds, bonds that the Fed may never sell, thereby leaving investors with plenty of money to invest in their wish list of favorite things? Instead, disheartened investors should ask the Fed, “What stock effect?”


The Fed thought it did something nice. But instead, something nice turned into something naughty, because the Fed spoiled investors with its bond buying and lulled them to sleep before awakening them with the taper clatter. So, when Santa checks his list, he might just decide to put coal instead of gifts in the Fed’s “stock-ing.” The summer turbulence showed that the Fed in the end seems to have about as much to give to the global economy as a mall Santa can give to a curlicued little girl.

Waking up to an empty tree
A major objective of the Federal Reserve’s activism is to suppress interest rate volatility. The Fed accomplishes this in three ways: by keeping its policy rate near zero percent, by buying bonds and by giving forward guidance as to the likely path of its policy rate. All of these actions help to suppress the term premium in bonds, which is the amount of yield that bond investors demand for uncertainties over various things, including the outlook for monetary policy. This combination has proved potent in delivering easier financial conditions by suppressing interest rate volatility and compelling investors to move outward along the risk spectrum.

What the Fed learned in the summer, however, is that despite its bond-buying spree it needs to adjust the mix or else it will wake up to an empty tree, with no gifts underneath to cheer global markets. The Fed will therefore put less emphasis on its bond buying and instead focus on its forward guidance in hope that it can convince investors that there will be plenty of presents under the tree for quite a long time, with the policy rate staying at zero probably until at least 2016. This, along with the Federal Reserve’s strong determination to boost inflation, is a reason for bond investors to stay focused on short and intermediate maturities and to avoid maturities beyond 10 years, where the Fed’s bond buying has had the most effect.

The shift toward emphasis on forward guidance has not been and will not likely be easy. In addition to losing some of its control over longer-term interest rates, the Fed’s bond buying has created risks to financial stability because it has compelled investors to move ever outward along the risk spectrum at ever higher prices.

Capital has moved literally around the globe as a result of central bank activism in developed countries. Christine Lagarde, managing director of the International Monetary Fund, noted as much this August at the Fed’s Jackson Hole Symposium, saying the cumulative net flow into emerging markets has increased $1.1 trillion since 2008, “squarely above its long-run structural trend by an estimated $470 billion.” Reversals of these flows could have a significant impact on market prices.

Many international investors are akin to tourists who have no intention of staying in their destination indefinitely. It’s moneytourism, resulting from the monetarist actions of central banks – but don’t expect central bankers to admit to playing any role in the tourists’ travel plans. They will play down the volatility that occurs when investors abruptly flee their destinations in a “transportation” system that has difficulty handling the speed and volume of today’s moneytourism “traffic” because financial intermediaries are either unwilling or unable to warehouse risk in the way they used to. This is why the beta, or the percentage by which yields change on fixed income securities relative to yield changes for U.S. Treasuries, has increased since May, much to the chagrin of investors who, like the Fed, put stock in the stock effect.

In the meantime, expect the beta on fixed income assets to remain elevated while the Fed pivots away from bond buying to forward guidance. Stay focused on fundamentals, because they will be the ultimate driver of prices and yields to their destination once the powerful technical influences diminish. Most of all, stay focused on the Fed’s policy rate, the gift that keeps on giving.

Emerging markets: differentiation on the rise – Lupin Rahman
Emerging market (EM) central bankers have certainly earned their holiday dinners this year. The challenging summer, when uncertainty about Fed quantitative easing (QE) policy whipsawed EM asset markets, has now given way to a period of controlled consolidation in markets with more breathing room for policymakers. As we look into 2014 and a Yellen-led Fed, the question for investors is how EM central banks are using this window – whether they have done enough in terms of setting up firewalls and contingency plans, and if not, where are the vulnerabilities.

Let’s start with the reaction to the summer sell-off. As markets priced in a higher probability of a Fed taper without economic growth, EM central banks were simultaneously faced with sharp currency weakness (10%–15%), a significant backup in local yields (+100 basis points, or bps) and across-the-board widening in risk spreads (75 bps – 100 bps) (all data from Bloomberg). Then, as outflows from the EM asset class gained momentum, the initial gap in prices was reinforced by a powerful feedback loop from forced selling to sharp currency weakness, and in turn to additional reduction in exposures in both local and external markets. The reaction from emerging markets was to focus on policies targeted to smooth volatility and provide U.S. dollar liquidity to the markets.

After the initial overshoot subsided and markets got more clarity on Fed leadership and U.S. economic data improved, EM policymakers shifted from the initial phase of crisis management to fine-tuning their policy toolkit. Importantly, the reaction function has varied across emerging markets based on economic and credit fundamentals, the stage of the business cycle and the extent of the external shock experienced. Countries with relatively large external financing needs relative to the stock of reserves, as well as high and increasing inflation, are undertaking a combination of tightening monetary conditions, currency intervention and measures to reduce capital outflows. For example, India, in addition to hiking the policy rate by 50 bps, introduced domestic USD swap facilities for local banks as well as measures to open local markets to foreigners; meanwhile Indonesia hiked rates by 100 bps and is also bolstering foreign currency reserves with bilateral swap agreements with China, Korea and Japan. Other economies where the current account is large but price pressures are declining are keeping policy rates on hold while allowing the currency to be the main adjustment valve for the economy. For example, South Africa has kept rates on hold as the 13% nominal depreciation in the rand de facto loosened monetary conditions amid moderating inflation and slowing growth. Finally, there is a group of EMs with modest inflation and lower external financing requirements; Mexico, Peru and Thailand, for example, are easing policy rates while also allowing their currencies to depreciate.

The challenge going forward is whether emerging markets continue to use this window of respite effectively. This is particularly important given the uncertainties over the timing and implementation of Fed tapering. Moreover, since September there has been lower volatility in EM assets, which may have implicitly decreased the urgency with which EM policymakers reorient their policies to the new realities of a world without Fed QE.

With that in mind, EM central bankers would be best advised to provide more clarity on their policy reaction functions and any contingency plans to contain volatility in currencies and rates and to provide USD liquidity should a period of stress return. The Central Bank of Brazil’s recent extension of its currency intervention program to 2014 and improved communication on the policy cycle is a good first step in this regard. EM governments are also well advised to continue with adjustment policies where needed in the fiscal and financial sectors to open up policy flexibility and the degrees of freedom to adjust to any further shocks.

Looking ahead, we expect 2014 to be a year of increased differentiation across emerging markets in terms of economic fundamentals, policy reactions and market outcomes – all of which will likely be accentuated by tapering and the withdrawal of QE liquidity. Given this outlook, country selection will be important: Favor economies whose initial macroeconomic conditions and policy buffers offer more immunity against currency and rate volatility over economies with high twin deficits and inadequate policy responses to current external vulnerabilities or future volatility (e.g., Turkey or India).

In addition, the anchoring of the front end of U.S. rates by a Yellen Fed together with foreign flow concentration in the belly and long end of EM local curves means that curve positioning will also be critical to generating returns. To that end, investors may want to position themselves in the front end of EM local curves that are more anchored by policy rates in economies expected to stay on hold in the face of any future currency weakness – e.g., Mexico or Poland. Other alternatives include positions in the front end of economies with strong balance sheets and clear policy contingency plans where excessive hikes are priced in versus the expected central bank policy rate path – e.g., Brazil.

Finally, as we move into a world with less QE liquidity and no meaningful macroeconomic tailwind, currencies will likely continue to be an important shock absorber for emerging markets and may face appreciation headwinds.

The practical aspects of global forward guidance – Ben Emons
Forward guidance is an enhanced form of communication: It lays out conditions for policy changes tied to forecasts on the direction of the economy. Forward guidance has become an increasingly common practice among global central banks. The Reserve Bank of New Zealand (RBNZ) started forward guidance in 1997; the Norges Bank and the Riksbank followed in 2005 and 2007, respectively. Nowadays, the Federal Reserve, the Bank of England and the European Central Bank use forward guidance as one of their main tools.

In general, the method of communicating forward guidance is to announce a probable path for short-term interest rates. Given the expectations hypothesis of the term structure of interest rates – i.e., that long-term rates are equal to the expected short maturity rate plus a risk premium that is constant over time – communicating a possible change in the policy rate could have a large effect on long-term interest rates when the central bank commits to a certain trajectory.

Central banks in New Zealand, Norway and Sweden have been able to establish credibility by providing a consistent policy rate path. The effect of this policy has been an increase of correlation between (expected) short-term and long-term interest rates over time – see Figure 2. The more entrenched forward guidance became, the more expected short-term rates influenced the direction of long-term interest rates. As these are relatively small, open economies and not engaging in large-scale asset purchase programs, these central banks were able to convey a desired rate path without causing uncertainty about future policy. As a result, they have not needed to strengthen their forward guidance.


In contrast, central banks in the major developed countries appear to have what St. Louis Fed President James Bullard recently dubbed a “dependency problem” between forward guidance and asset purchases. Financial markets may find it reasonable that the state of the economy affects both tools and therefore may not distinguish between “tapering” purchases and “tightening” policy. Policymakers, on the other hand, have a choice to alter the settings of one tool versus the other. When markets respond to tools the same way, but central banks signal a change in one tool and not another, uncertainty about future policy tends to increase. This means forward guidance would have to be strengthened each time the central bank intends to slow asset purchases or plans to shrink the size of its balance sheet. By strengthening forward guidance, correlation between short-term and long-term interest rates in the U.S., UK and Europe may increase, shown in Figure 3. Like in New Zealand and Scandinavia, expected short-term interest rates in the U.S. and Europe could exert greater influence on long-term rates.


When forward guidance is strengthened as a result of the dependency problem, it becomes a (conditional) promise that is more difficult to renege on. The consequence is that policy rates of developed central banks could take much more time to normalize. Forward guidance in these major developed economies may transform to what has become custom in New Zealand, Sweden and Norway: a longer projected path of interest rates under different economic scenarios.

The Author

Tony Crescenzi

Portfolio Manager, Market Strategist

Lupin Rahman

Portfolio Manager


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