Looking for a Goldilocks taper tantrum

Investors should steel themselves. The Federal Reserve is going to raise rates, and it won't be pretty.

The latest note of caution came from former Fed chairman Alan Greenspan, who this week predicted that a re-run of the 2013 "taper tantrum" was inevitable. The process of normalising interest rates "is going to be very rocky", he warned. This echoed an earlier speech by New York Fed president Bill Dudley on Tuesday, when the influential central banker said it would be "naive" not to expect market rumbles.

Their warnings are timely. While bond markets have been far from tranquil recently, with a European rout spreading to the US this month, expectations for when lift-off happens continue to be pushed out. Regardless of when it occurs, many investors and analysts are convinced that a Fed rate increase has been so widely discussed and thoroughly dissected that any market impact will be muted to non-existent, or pass quickly like a summer squall.

Such consensus is worrying - and potentially dangerous. As Mr Dudley pointed out, while a rate increase has been well-telegraphed, after six years of zero interest rates and $4tn of quantitative easing (QE), lift-off will still send a clear signal that the era of ultra-loose monetary policy is finally over.

Regime changes like this tend to be accompanied by turmoil, even if they are expected. Markets are currently pricing in a far gentler interest rate path than the Fed itself forecasts, but the first increase is likely to snap investors out of their complacency. That will reverberate across markets.

Moreover, the Fed's new rate hiking toolkit - necessary because QE has neutered the traditional way of lifting rates - may have been tested out, but not under live fire.

Most economists are confident that the US central bank has the ability to keep the Fed funds rate under control. But this will be the most experimental rate hiking cycle in modern history, and the side-effects of pushing and pulling various policy levers are unknowable.

The crucial question is how investors react to any Fed-induced bond market swoon. The concern is that retail investors are unprepared for losses on supposedly safe fixed income, and will yank money out of funds that will be forced to dump holdings in already illiquid bond markets, creating a negative feedback loop.

The liquidity drought has already exacerbated the mini taper tantrum that has rattled global bond markets in recent weeks. Even the mighty US Treasury market has gyrated wildly on relatively modest volumes, and some pessimists fear a wave of selling could overwhelm the much more illiquid corporate bond market.

The shriller doom-mongering looks misplaced, however. Retail investors are flightier than pension funds and insurers, but have few viable alternatives, and massive outflows from the US junk bond market last summer did not cause the carnage that pessimists would have predicted. Management turmoil led investors to pull $350bn out of bond behemoth Pimco in the year to March 31, but the market took that in its stride too.

The danger of Treasury yields rocketing higher also looks overdone. The International Monetary Fund recently warned a rise of 1 percentage point was "quite conceivable" but there is enough money sloshing around the world to buttress the US government bond market.

The 10-year Treasury yield is higher than 86 per cent of the $20tn of government debt in JPMorgan's Global Bond Traded Index, and the recent weakness predictably attracted droves of foreign investors to this week's bond auctions.

Nonetheless, some nervousness is healthy. The lack of broader turmoil triggered by Pimco's turmoil is a particularly wrong-headed reason for optimism. The asset manager happened to sit on massive short-term positions in derivatives and agency debt that were easy to turn into cash as investors demanded their money back, which meant it didn't have to try to liquidate harder-to-sell securities.

Indeed, Mr Dudley's speech appears to be a signal that the central bank fully expects short-term tremors, and will not be deterred by them. The challenge is arguably to manage a "Goldilocks" hiking tantrum: just enough turbulence to wipe froth out of financial markets and restore some sobriety to asset prices, but not a full-blown crash that could derail the economic recovery.

© The Financial Times Limited 2015. All rights reserved.
FT and Financial Times are trademarks of the Financial Times Ltd.
Not to be redistributed, copied or modified in any way.
Euro2day.gr is solely responsible for providing this translation and the Financial Times Limited does not accept any liability for the accuracy or quality of the translation