ECB, Fed pile risk upon risk: James Saft

November 12, 2013

Nov 12 (Reuters) – With the European Central Bank and U.S.
Federal Reserve pulling the same way, global interest rates will
be lower for longer, feeding an ongoing rally in risky assets.

But since monetary policy has a bigger impact on financial
markets than the real economy – arguably, anyway – the bigger
the paper gains get, the more acute the risks become.

The ECB surprised virtually everyone last week when it cut
its key lending rate to 0.25 percent, reacting to an
uncomfortable slide in inflation and an equally vexing rise in
the value of the euro.

Following on the Fed’s decision not to slow bond purchases
in September, this marks the second time in less than two months
that a major central bank has shocked investors with dovish

And to judge from the noises coming out of the Fed, we are
running out of excuses for being surprised.

“Although the series of upside surprises in economic data
releases in the U.S. recently has increased the risk of an
earlier taper, we believe forward guidance could be used by the
Fed to signal that policy will remain ultra-loose for
considerably longer than currently indicated,” Societe Generale
economist Klaus Baader wrote in a note to clients on Monday.

The taper, the prospect of which was taken by investors as a
tightening of conditions over the summer, seems unlikely at the
Fed’s next meeting in December. Coming to the end of his tour of
duty, Fed Chairman Ben Bernanke would probably prefer to leave
the opening gambit to his successor, Janet Yellen, delaying any
move at least until March.

An academic paper released last week by key Fed economists
may provide a clue as to how, and why, the Fed may decide to try
to persuade the market that it intends to keep its foot on the
gas for longer (here).
Called forward guidance – essentially central banker-speak for
promising to follow some course of action in the future – the
tactic in this case probably involves pledging to keep rates
pinned at low levels until unemployment gets to just 5.5
percent, a full point lower than current guidance and almost two
points below the current U.S. jobless rate.

In other words, if we get a taper, it may come with more
aggressive forward guidance as a sweetener.


Clearly, both the ECB and the Fed have plenty of troubles to
manage. Inflation is well below target in both economic areas,
and there are indications that it is in a multi-year downtrend.
Unemployment is also an issue, with mass youth unemployment in
parts of the euro zone threatening to create a lost generation
in the labor force.

Similar forces are at work (or perhaps not) in the United
States, as the following comments from Bernanke on Friday

“There is an awful lot of slack in the labor market – a lot
of young people living with their parents and the like – and
that is a very important imperative.”

The cost of addressing these issues with monetary policy is
a potentially dangerous distortion of risk-taking in financial
markets. Just look at the mania in stock markets for riskier
investments – from Twitter’s hugely successful initial public
offering to the rollicking gains in highly speculative 3-D
printer stocks. While anyone who tells you this is definitely a
bubble is at best over-confident, you should invite anyone who
tells you it definitely isn’t to play poker.

There are other types of risks that build as monetary policy
is kept so loose for so long. One is that governments are lulled
into a false sense of security, allowing them to put off needed
reforms because the so-called bond market vigilantes have been

A good example of this is in the United States, with the
interplay between the Fed and the warring political parties.
After having cited the government shutdown as a reason to not
taper, politicians might be excused for believing they have a
license to grandstand and delay.

The same is definitely true for emerging markets, which may
be frittering away the short-term reprieve from tighter
conditions they were given when the Fed held off on tapering.

“Emerging market countries have done virtually nothing since
then to put themselves in a better position when a taper comes,
and if anything more speculative capital has gone into these
markets, making these currencies even more vulnerable to a sharp
selloff,” hedge fund manager Stephen Jen of SLJ Macro Partners
told clients in a note.

Expect, in other words, a bigger rally in any number of risk
assets, followed by a bigger and perhaps more violent selloff.

(At the time of publication James Saft did not own any
direct investments in securities mentioned in this article. He
may be an owner indirectly as an investor in a fund. You can
email him at and find more columns at

(Editing by Douglas Royalty)

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