One of Janet Yellen's first challenges as Federal Reserve chairman will be figuring out how to cushion against a lurch in interest rates when she pares the pace of the central bank's bond buying.
After sending 10-year Treasury yields more than a percentage point higher by fueling taper expectations in May and June, policy makers now are grappling with their options when they do reduce debt purchases that have swelled their balance sheet to a record $3.91 trillion.
The Fed's failure so far to convince investors that tapering on its own doesn't constitute a tightening of policy creates the risk of more market volatility as the central bank communicates about tools it's never used.
"Now, this is challenging: We're in unprecedented circumstances, we're using policies that have never really been tried before -- and multiple policies -- and we're trying to explain to the public how we intend to conduct these policies," Yellen, the nominee to replace Ben S. Bernanke, told the Senate Banking Committee Nov. 14 at her confirmation hearing in Washington. "So, it is a work in progress, and sometimes miscommunication is possible."
Since lowering their benchmark interest rate to near zero in December 2008, Fed officials have relied on bond buying and forward guidance about their plans to try to spur growth. They've suggested pushing back the timeline for rate increases, emphasizing they won't raise borrowing costs until inflation climbs, or lowering the interest they pay on the cash that banks park at the central bank as ways to add stimulus.
"It's been a struggle," said Ward McCarthy, chief financial economist at Jefferies LLC in New York. "With the shift to balance-sheet policy, there's not a whole lot to fall back on -- both in terms of making decisions on how to conduct balance-sheet policy and how to communicate it. It's a new experience both in and out of the Fed."
This is an interesting situation because no one knows exactly how it will play out. Currently, Janet Yellen and a number of her colleagues at the Fed wish to continue with the present policies because the US economy is softer than they would like. However, plenty of other people, including corporate leaders and investment managers, would like the Fed to 'bite the bullet' and end the suspense by commencing tapering.
Investors' views vary in line with their positions. Those who are fully invested would like the Fed to hold off so that they can have an even better year and at least a further rally in the first quarter of 2014. Conversely, those who have already lightened and / or are partially hedged would like the Fed to commence tapering immediately.
Meanwhile, the rising trends on Wall Street have shown that more investors are holding on or even increasing positions, rather than selling. However, this is a momentum play in an overextended and somewhat overvalued market. Therefore, a number of the institutional trend runners will be standing, metaphorically speaking, near the exit door. This can only end in a shakeout, and once underway, it is likely to be swift and self-feeding, driven by profit taking and short selling.