While the last 2 weeks have seen numerous Fed heads, most vociferously Bill Dudley [14], warning of 'complacency' in markets, fearsome of low volatility and worried about low risk spreads. Of course, investors don't care - don't fight the fed unless the fed tells you to sell, appears the mantra-du-jour. Fed communications are not working... and so they have left it to their mouthpiece - WSJ's Jon Hilsenrath - to explain that they are indeed concerned at just how risk-free markets have become..."Federal Reserve officials, looking out at mostly calm financial markets, are starting to wonder whether tranquility itself is something to worry about. [15]"
As WSJ's Jon Hilsenrath explains, [15]
Federal Reserve officials, looking out at mostly calm financial markets, are starting to wonder whether tranquility itself is something to worry about.
So far this year the U.S. economy has suffered a brief economic contraction, the Fed has begun winding down a major bond-purchase program meant to spur growth, the Obama administration has clashed with Russia over its annexation of Crimea, China's economy has slowed and the Middle East has become a cauldron of civil strife.
"Markets" don't care...
Yet, looking at Wall Street stock and bond trader screens, the world looks like a model of stability.
The Dow Jones Industrial Average, up a steady if unspectacular 1% since the beginning of the year, has consolidated big gains registered last year. Yields on 10-year Treasury notes have fallen even though inflation—which typically sends bond yields up—has been inching higher from very low levels.
Other measures of risk aversion and market volatility show an especially striking sense of investor calm. The VIX, which tracks expected stock-market fluctuations based on options trading, has gone 74 straight weeks below its long-run average—a run of steadiness not seen since 2006 and 2007.
Moreover, the extra return that bond investors demand on investment-grade corporate debt over low-risk Treasury bonds, at one percentage point, hasn't been this low since July 2007. The lower this "spread," the less risk-averse are bond investors.
The Fed is worried...
The worry at the Fed is that when investors become unafraid of risk, they start taking more of it, which could lead to trouble down the road.
"This indicates a great deal of complacency," Richard Fisher, president of the Federal Reserve Bank of Dallas, said in an interview. "When you get complacency you're bound to be surprised at some point."
But it's the Fed's fault...
The Fed has given root to the sense of calm by offering investors assurances that interest rates will stay low far into the future. Its policy statement says officials expect to keep short-term rates near zero for a "considerable time" after the bond-buying program, known as quantitative easing, ends later this year.
...
"It is a problem of their own making. They can't have it both ways," said Martin Barnes, chief economist at BCA Research, an investment-advisory firm. "If they want to sustain zero interest rates and push up asset prices, how can they expect to have that with no excesses and no risk taking?"
...
"I cannot tell you for sure when this does get unwound," Mohamed El-Erian, former chief executive of the bond fund Pacific Investment Management Co., or Pimco, said in an interview of the recent period of market calm. "When it does we are going to be reminded of what happened last May and June."
...
"My concern is that keeping rates very low into late 2016 will continue to incentivize financial markets and investors to reach for yield in an economy operating at full capacity, posing risks to achieving sustainable growth over the longer run,"
Translating...
"we are very pleased you all benefitted from the irrational surge in stock prices, and plunge in corporate bond spreads but it's got a little out of hand and we'd like you all to form an orderly queue and leave the building... do not panic"
So - how does the Fed fix this problem? We suggest QE-Next should monetize VIX futures.