Markets await Bernanke fearful of sharp and discontinuous rates rises
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Markets await Bernanke fearful of sharp and discontinuous rates rises

Wall Street was close to panic last week as fears of rising US Treasury yields brought capital markets to the brink of closure.

Whenever Ben Bernanke speaks, markets are in thrall, but the intensity of focus to every nuance of every word when he takes to the microphone after the Federal Open Market Committee meeting this Wednesday will be extraordinary.

Touring the executive floors of the leading Wall Street firms last week, Euromoney found the mood to be one of confusion, uncertainty and fear about the prospects for US interest rates.

Ben Bernanke, Fed chairman

If the Federal Reserve’s aim a few weeks ago was to reintroduce two-way risk into credit markets showing signs of bubble-like inflation, then its senior executives’ talk of possible early tapering off the pace of bond buying has certainly achieved that. At the start of May, 10-year US Treasury yields hit a low of 1.63%. By the middle of last week they had risen to 2.23, a 60 basis point rise that had been accompanied by outflows from bond and credit funds and signs of a sell-off reaching the point where the first signs of panic were becoming visible.

On Wednesday, June 12, Euromoney sat down with the head of investment banking at one firm who saw a worrying picture in the markets for debt and equity capital raising, as rates climbed.

“Some parts of the investment-grade primary debt markets are now pretty much closed,” said the head. “It feels as if we are at an inflexion point. The leveraged loan market remains open, however, as does the IPO market.

“Money wants to go into the US equity market because there’s a big US dollar theme playing as a lot of money is being pulled out of the emerging markets. But even in the US equity capital markets, you couldn’t sell much in the way of yield equity right now. You probably couldn’t do a Reit, for example.”

Even as he spoke, Dealogic was reporting that year-to-date global investment-grade corporate DCM volume had reached record levels of $853 billion by mid-June 2013, perhaps itself an expression of exuberance that loose US monetary policy might be storing up troubles for an eventual burst in the financial system.

Can Bernanke and his colleagues do enough to curtail excesses in the financial markets fuelled by a now fraying belief in a one-way bet on monetary accommodation without closing down access to capital raising for productive users? Certainly the Fed is working hard to gauge the impact of its actions and its messages about potential actions. Last week it had its ears firmly to the ground.

Euromoney’s next call was to a bank chief executive. He said: “My understanding is that the Fed had a few people from banks and corporations in yesterday to gauge the potential impacts of rising rates. The Fed was in listening mode, but my own sense is that while the US economy is recovering, that recovery is still fragile.

“The consumer will lead the recovery and while there is now a floor under house prices and financial markets have been strong, the uncertainty is still over jobs. That’s what the Fed is focused on.

“Our rates traders’ worry on the employment number the previous week was that anything under 140,000 would show the recovery was stalling, while anything over 200,000 would raise the risks of imminent tapering. It came in at 170,000, right in the middle of that range. The Fed is walking a fine line here. We all are.”

The key to all this lies beyond monetary policy. For the economic recovery to move beyond being stimulus dependent and become self-sustaining, US corporations must have confidence to hire people and expand capacity. Corporate leaders appear to be anxious about fiscal policy, uncertainty over taxes, energy policy and, for small and medium-sized companies, costs of healthcare.

The IMF’s latest pronouncements on the US economy might have helped calm financial markets. Of course, US policymakers will ignore the IMF’s advice on slowing what it calls the too-rapid pace of an ill-designed fiscal adjustment.

The US takes no account of the IMF whatsoever, but markets will note that while the fund’s economists still project 1.9% GDP growth for the US this year, down from 2.2% in 2012, it has cut back to 2.7% its forecast for growth in 2014, from the 3% outlined in the IMF’s world economic outlook in April.

By the end of last week, markets seemed to have calmed down a little. Yields on 10-year treasuries rallied down to 2.13%, as traders took the view that, given continuing uncertainty over the fragility of economic recovery, anything over 2.25% might be a buying opportunity.

The global head of capital markets at one leading firm told Euromoney: “Even amid the rates sell-off in the past two weeks, we’ve been as busy as we’ve ever been. The US market is showing real strength and yes you can get yield equity deals, such as MLPs [master limited partnerships] and utilities, done even now.”

That’s nice to hear, but one thing is for sure: volatility is back. Even if inflation fears are contained and the outlook for GDP growth is moderately positive, the markets have had a sharp reminder of the carnage that rapidly rising interest rates can inflict.

This is the final message from the head of investment banking at another leading US firm: moderate GDP growth does not pave the way for gradual and easy upswing in rates.

“People who have talked about a gradual rise in interest rates don’t understand the rates markets,” said the head. “Markets are discounting mechanisms. If the markets do become fairly convinced that US 10-year treasuries will yield, say, 350bp by the end of 2014, then they could go to 300bp very quickly now. Market rates won’t rise by 25bp each quarter for six quarters in a gently rising slope. Moves will be sudden, sharp and discontinuous.”

The biggest worry for investors is that regulation designed to improve the stability of the banking system – that has removed proprietary trading and reduced market-making inventory by increasing RWA allocation and associated equity – has robbed the market of an important buffer to ease it through such sudden moves.

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