Monday, September 22, 2014

Watch the UK as the Fed exits

Last week, the IMF voiced concerns about excessive risk taking in the financial system (via Reuters):
The global economy faces a growing risk from big financial market bets that could quickly unravel if investors get spooked by geopolitical tensions or a shift in U.S. interest rate policy, the International Monetary Fund said on Wednesday.
In particular, it warned about downside risk from an unwind from leveraged positions taken on because of easy US monetary policy (emphasis added):
But it also warned that financial market indicators suggested investor bets funded with borrowed money looked "excessive" and that markets could quickly deflate if there were surprises in U.S. monetary policy or the conflicts in Ukraine and the Middle East.

As the IMF put it in its technical language, "New downside risks associated with geopolitical tensions and increasing risk taking are arising."
These warnings have been heard before, most recently from Seth Klarman (also see yesterday`s post 3 reasons to get more cautious on stocks). So what happens when the Fed stops QE and starts to tighten?

Macroprudential vs. monetary policy
Fed Chair Janet Yellen's recent July 2, 2014 speech on Monetary Policy and Financial Stability states that the Fed would like to rely on macroprudent policies as monetary policy is too blunt a tool (emphasis added):
In my remarks, I will argue that monetary policy faces significant limitations as a tool to promote financial stability: Its effects on financial vulnerabilities, such as excessive leverage and maturity transformation, are not well understood and are less direct than a regulatory or supervisory approach; in addition, efforts to promote financial stability through adjustments in interest rates would increase the volatility of inflation and employment. As a result, I believe a macroprudential approach to supervision and regulation needs to play the primary role. Such an approach should focus on "through the cycle" standards that increase the resilience of the financial system to adverse shocks and on efforts to ensure that the regulatory umbrella will cover previously uncovered systemically important institutions and activities. These efforts should be complemented by the use of countercyclical macroprudential tools, a few of which I will describe. But experience with such tools remains limited, and we have much to learn to use these measures effectively.
Bloomberg reported that it has put veteran central banker Stanley Fischer, who was the thesis advisor to both Ben Bernanke and Mario Draghi, on the problem:
The Federal Reserve has created a committee led by Vice Chairman Stanley Fischer to monitor financial stability, reinforcing its efforts to avoid the emergence of asset-price bubbles.

Joining Fischer on the Committee on Financial Stability are Governors Daniel Tarullo and Lael Brainard, according to the central bank’s latest Board Committee list.

Fed officials want to ensure that six years of near-zero interest rates don’t lead to a repeat of the excessive risk-taking that fanned the U.S. housing boom and subsequent financial crisis.
As the economy recovers and the Fed begins to normalize interest rates, it will be the job of these macroprudential policies to combat and mitigate the effects of any financial bubbles that easy monetary policies may have blown.

The UK as a test case
Will this approach be successful, or will the markets have to endure another crash because of miscalculations at the Fed? One way investors can gauge the likely success is to watch the UK experience. Britain appears to be slightly ahead of the US in its economic recovery cycle.

Former Fed vice chair Donald Kohn recently spoke to the British Bankers' Association and address this very issue. While he believed that the British financial system is resilient enough that when the MPC raises interest rates, he said (emphasis added):
But exit is not without its risks and dangers, especially after a long period of very low interest rates and low market volatility. And exit is likely to occur at different times in different jurisdictions globally, adding to the complexity and potential complications. As I emphasized earlier, it’s the tail risks – the unusual developments – that often pose the greatest threats to financial stability. The question is whether the long period of low rates and low volatility has led to a mispricing of risks through reaching for yield, herding, or other types of behaviours. If it has, the potential for very sharp adjustments would be higher, with possible unanticipated consequences for both borrowers and lenders.
He added the caveat that central bankers are in uncharted waters:
Never before have the monetary authorities engaged in the sorts of unconventional policies that have been widely utilized over the past six years. So, none of us has any experience with the asset price movements associated with the policies, or those that could occur as they are exited. As noted, the complexity of forward planning and risk management is heightened by diverging economic prospects around the globe.
In the end, Kohn expressed confidence that central bankers had everything under control:
Most likely all will go well; unconventional policies will be unwound with only the sorts of gains and losses that usually accompany policy shifts and don’t threaten financial stability. But this is an unusual challenge for both the authorities – including new macroprudential authorities like the FPC – and the private sector. One that we must get right.
The task of exiting such an unprecedented  level of stimulus after the Global Financial Crisis is the greatest challenge facing the Federal Reserve and global central bankers.

Will macroprudential policies work? I have no idea. No doubt the risk of a policy mistake is enormous, but at least investors have the UK as a laboratory of what might go wrong.

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