How A More Transparent Fed Has Increased Market Volatility

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Ben-BernankeTo investors, volatility is not a good thing. To many analysts, volatility is the definition of risk.

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The volatility of bond prices is the essence of risk to the investor in bonds because it means that one is never sure what price one might be able to buy…or sell bonds at…if one needs to trade bonds.

One could argue that the only real concern about volatility is just on the down side…what is the probability that the price of bonds will fall. But, overall volatility, both on the upside as well as on the downside, is important because it captures just how likely it is that the price of a bond might change, and, hence, the essence of how stable the price of a bond might be.

Volatility may change for many reasons. For one kind of risk, interest rate risk, the possibility of the general level of bond prices changing may vary over time. Just two weeks ago I discussed the possibility of rising interest rates…falling bond prices…and how that might impact investment decisions related to longer-term bonds. See “Risks of Rising Interest Rates for Long Term Bond Holders.”

Interest rates may rise over the next two years as the economy gets stronger and this would mean that bond prices would be declining over this same time period. The volatility connected with interest rate risk has increased substantially over the past year.

Now, I would like to discuss another type of situation, one that recently has increased the volatility of longer-term bond prices and hence made holding longer-term bonds riskier.

On Tuesday, the prices of Treasury bonds fell. The reason given for this decline in prices went something like this. After a report was released by the Institute for Supply Management (ISM) indicated that the United States economy in October seemed to be unaffected by government shutdown and the debt-ceiling debate, bond prices fell.

This news was bad news for the bond market because analysts interpreted this information as having an impact on the thinking of officials of the Federal Reserve System and the rate at which the Fed was purchasing bonds to hold in its portfolio.

The current policy of the Federal Reserve is to buy $85 billion in government bonds and mortgage-backed securities every month. But, in recent months, the Fed has decided that we were approaching a time when it might begin to reduce, to “taper”, the volume of securities it purchased every month because the economy was getting stronger.

This whole idea of “tapering” came about because Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System told Congress in testimony on May 22, 2013, that the Fed might begin to “taper” the monthly size of its bond-buying program.

Although interest rates had begun to rise previous to this time for other reasons, they now began to increase much more rapidly. On May 22, the 10-year US Treasury bond traded to yield just over 2.00 percent. A month later, the 10-year bond yielded over 2.50 percent. In early September the 10-year yielded almost 3.00 percent.

The consensus of investors was that the Federal Reserve would begin to “taper” its purchases after the September meeting of the Board of Governors.

The Board met on the 17th and 18th of September. The minutes of the meeting were released soon after the meeting. The decision of the Board was not to begin the “tapering” of purchases right away. The information on the strength of the economy was not strong enough to warrant a reduction in purchases at this time. Rather than beginning “tapering” in the immediate future, the time table was pushed back to something like March 2014.

Immediately, bond prices began to rise…and interest rates fell. The yield on the 10-year Treasury bond dropped from 2.85 percent on September 17 to 2.50 percent a little more than a month later.

The market began to show a little weakness on Friday, November 1, but the news coming out on Tuesday, November 5 seemed to “spook” investors a little more. The interpretation of the ISM data was that the economy was not going to get weaker because of the situation of the government in Washington, D. C., and that the Federal Reserve probably would begin to “taper” its purchases sooner than the March date that had been the “current” market consensus.

Now, the market is waiting for the first estimate of the third quarter GDP numbers, to be released on Friday. If the number is weak, investors will assume that the Federal Reserve will begin to “taper” later rather than sooner. If the number comes in strong, the opposite reaction can be expected.

Obviously, the Federal Reserve, at this time, is adding to the volatility of the bond market. This is the worst of all worlds for the Federal Reserve. The Federal Reserve wants stable markets…markets that do not jump this way and that way on the basis of how investors believe it is going to act.

And, this is exactly the opposite of what Ben Bernanke wanted to happen during his tenure as Chairman. In fact, Mr. Bernanke set out explicitly to increase the transparency of Federal Reserve operations, holding press conferences to explain Fed decisions and changing the information released so as to provide “forward guidance” to market participants.

In my mind, the efforts made by Mr. Bernanke have had just the opposite effect from that intended. For one thing, the people at the Federal Reserve are no better at projecting the future than other “trained” economists. In fact, the track record of the Fed in projecting the economy over the past 10 to 15 years has been pretty abysmal. (See the new book by Alan Greenspan, former Chairman of the Board of Governors titled “The Map and the Territory.”)

However, because the Fed has become so “transparent” and has even provided “forward guidance” the market comes to “hang onto” whatever it is the Fed is saying. Thus, when changes occur, because forecasts don’t come true, the market rushes to incorporate the latest interpretations into market prices. Further changes cause the market to rush off into other directions. And, the adjustments tend to be in “jumps” rather than in a smooth transition.

The bond market has become more volatile…more risky…because of the behavior of the Federal Reserve.

Therefore, we introduce a new risk component that investors in the bond markets have to deal with “central bank risk.”

Volatility is not a good thing. The volatility of the market caused by the central bank is awful!

About John Mason

John MasonJohn has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.


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John Mason

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