Bloomberg’s Mike McKee conducted an interesting interview with FRBNY President Bill Dudley.
When asked about concern surrounding the potential for a spike in interest rates, President Dudley offered two points (at about the 8 1/4 minute mark). I take issue with each.
(1) President Dudley noted that “people are talking about this [a spike in interest rates] all the time.” Based on his experience, when events are anticipated, “things don’t happen.”
My sense is that this is an overly simplistic view. Three illustrative examples immediately spring to mind.
NASDAQ: Although many market participants were “talking about” a correction in tech stocks for months before the collapse beginning in April 2000, this did not “prevent” the Nasdaq from falling by 78%.
ARGENTINA: The Argentine peso collapse in 2002 was the most telegraphed crisis in the history of recent financial crises. Although anticipated, the peso plunged by 73% versus the USD and the economy sunk by 16% in real terms.
CARRY TRADE AND BANK OF JAPAN: In late 2005 and early 2006, market participants were “talking about” the impact of Bank of Japan’s exit from its Zero Interest Rate Policy (ZIRP) scheduled for March 2006. It was widely discussed and anticipated. Nonetheless, the Nikkei peaked at the end of March 2006 and plunged by 19% into June. Similarly, the exit from ZIRP triggered a correction in emerging market currencies – despite the fact that everyone was talking about it.
The bottom line is that expectations do not preclude events from occurring. What could be argued is that when events are anticipated, the potential damage is reduced, since economic agents are forewarned and can protect themselves. This assumes, however, that the agents know the “correct” response to such signals.
(2) President Dudley noted that the risk of a spike in interest rates is diminished as the Fed holds many of the “long duration assets” on its balance sheet, resulting in less risk for the private sector.
This is false for many reasons – as it both focuses on flows versus stocks and misses the linkage between public and private debt markets.
Many interest rates in the private sector are based on their spread to Treasury yields. So any move higher in Treasury rates will immediately impact private credit markets. Similarly, the stock of Treasury debt dwarfs flows. So, if private market participants (either domestic or foreign) get nervous, their resultant selling paper will drive yields sharply higher still.
Going forward, the optimal path for the Fed is to more precisely hone its communication and be less dismissive of realistic risks.