In December 2008, with the global financial system teetering on the brink of meltdown, the Federal Reserve Board slashed benchmark interest rates to virtually zero, where they’ve remained ever since. Also for the first time in its history, the Fed launched massive bond-buying programs (known as quantitative easing) using newly minted money. Although the real economy has responded only haltingly to the abnormal magnitude and method of monetary stimulus, a rising tide of liquidity lifted most corporate boats, underwriting hefty gains in many sectors of the U.S. equity market.
Now, however, the Fed is intent on normalizing monetary policy. The first step in that process is “tapering” the central bank’s $85 billion monthly purchases of Treasury securities and mortgage-backed bonds. Yet judging from the “taper tantrum” thrown by the stock and bond markets after trial balloons on the subject were floated by multiple Fed officials last spring, this isn’t the kind of normalcy investors might welcome.
And with good reason, according to the government’s new Financial Stability Oversight Council. Created by the Dodd-Frank legislation in the aftermath of financial crisis, the FSOC is charged with spotting weak links in the financial system before they break. As part of its 2013 Annual Report, the council dutifully analyzed the potential impact of a sharp backup (rise) in bond yields, which many analysts and investors fear could happen as the Fed leaves the markets to their own devises.
The FSOC agrees that the road to normalcy could be full of potholes — and not just for investors exiting the 30-year bull market in bonds.
“Yields and risk [premiums] are likely to rise from their current low levels,” the FSOC concludes. “The speed of this adjustment is important to financial stability. While a transition to a more normal yield environment might occur gradually over years, there is a risk [to the financial system] of a sudden spike in yields.” Specifically, an external shock or a drop in risk appetite could trigger “an adverse feedback loop of investor losses, forced asset sales, lower asset prices, higher market volatility, and further decreases in risk appetite.”