The Fed and selective information bias in markets

Many academic theories rely on the assumption that markets were information efficient. However, this assumption appears to be proven false in reality again and again. Reactions in financial and commodity markets after the release of the FOMC statement on June 19, 2013 provide the latest example. Moreover, the developments support more the thesis of behavioral finance that there are selective information biases among traders and investors.

For the time being, the Fed continues its bond purchasing program with an unchanged total volume of $85bn. However, the FOMC statement also pointed out that “the Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes”. This already indicates that the FOMC would also be ready to increase the volume of bond purchases again after tapering the volume if incoming economic data were suggesting a slower economic pace than expected. During the press conference, Fed chairman Bernanke explained the possible path of reducing step by step the volume of bond purchases. The FOMC might start later this year and end the program completely by the middle of next year.

However, the markets obviously totally overheard the conditions attached to this possible schedule. This scenario outlined depends on the condition that economic data coming in has to confirm the projections of the FOMC. Also during the press conference, Mr. Bernanke pointed out that the volume of QE3 could be increased again if the economic development is less favorable.

Many commentators stated that tapering the bond buying program would be the end of expansionary monetary policy. This is absolute nonsense for several reasons. First, even if the FOMC will reduce the volume of bond purchases as outlined by Fed chairman Bernanke during the press conference, the Fed will still increase the amount of bonds held until mid-2014. Second, an end of monetary expansion is usually defined as a shift in policy towards a restrictive regime. However, holding a constant amount of bonds by the Fed does not imply that policy gets restrictive. The Fed policy might only become less expansionary. Taking the foot from the gas pedal does not mean to step immediately on the brake!

Third, an end of unconventional ways to provide liquidity to the financial system does not imply that the conventional ones would be closed too. Financial institutions having access to the Fed could still obtain funds by borrowing from the Fed. The yields on medium- to long-term US Treasury bonds have still some upside potential. But the steeper the yield curve gets, the more attractive will be the risk/return profile of carry-trades. Banks could then buy US Treasury paper, which will be refunded by repo operations with the Fed. Thus, banks might even compensate the decline of demand for Treasury and mortgage bonds by the Fed.

An end of expansionary monetary policy furthermore requires that the FOMC would increase the Fed Funds target rate. Again, the FOMC statement does not provide any hint that this would be the case any time soon. The FOMC stated “the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent,…”. According to the projections, only three members expect a rate hike in 2014, while the broad majority expects the first rate hike in 2015.

The development of the US unemployment rate remains the key for the further direction of the Fed policy. During the months of falling unemployment rate, the bond bulls argued that the decline was only due to people leaving the workforce as conditions to find a job were hard. We always argued that this is a normal movement, which will reverse once conditions improve. The labor market figures released earlier this month indicate that this turning point might have been reached. Thus, the unemployment rate might decline at a slower pace than the consensus at Wall Street expects due to persons returning back to the workforce. But in this case, the monetary policy of the Fed is likely to remain expansionary longer than the market currently prices in.

The Fed Funds futures at the CME discount a hike of the Fed Funds target rate already by December 2014 with a probability of more than 50%. Thus, the market is far ahead of the Fed and probably will have to revise its expectations down again.

If the major buyer in a market declares that he will reduce his purchases, the normal reaction is that prices decline. Therefore, the rise of medium- and long-term US Treasury yields is justified. Thus, the crucial question is, how far will yields rise.  A good starting point is to look at the spread of the 10yr US Treasury yield over the 3M T-Bill rate or the 3M US Dollar Libor rate. Currently this spread is at 250 and 227 basis points, which is well above the mean of monthly data since January 1984. However, both spreads are less than 1 standard deviation above their respective mean. Thus, the spread still has some upside potential. But on the other hand, it is also less likely that the spreads would move deep into the extreme zone, which was normally reached after a period of strong growth and a shift towards a restrictive monetary policy. Therefore, a yield on the 10yr US Treasury note at 2.75% could already be a buying opportunity and close to 3.0% a strong one.

The reaction in the stock and commodity markets following the FOMC statement and the press conference by Fed chairman Bernanke are not justified. First, as shown above, the tapering of the bond buying program later this year does not constitute an end of an expansionary monetary policy. Furthermore, reducing the volume depends on economic growth and a decline of the unemployment rate. Both factors are normally positive for company profits and thus also for the stock market. Second, the yield spread is one of the best indicators for the stock market. A rising yield spread is usually leading to a higher yoy-change of the S&P 500 index. Since 1985, the percentage change of the S&P 500 index one year later was 3.5 times the spread (in percentage points) between the yield on 10yr US Treasury notes and 3m T-Bills. Thus, the spread widening should normally be positive for the stock markets going forward.

All in all, we come to the conclusion, that the market was very selective in interpreting the message send by the FOMC and Fed chairman Bernanke. Besides neglecting some of the information presented, the market also did not interpret the message correctly. Tapering the bond buying program is not the end of expansionary monetary policy. US President Franklin D. Roosevelt stated in his first Inaugural Address “the only thing we have to fear is fear itself”. However, the markets wanted to be fearful. Warren Buffet’s advice to be fearful when others are greedy and greedy when others are fearful might be invaluable again currently.