Ben Bernanke, former US Federal Reserve chairman, told a Congressional panel in May 2013 that within the following few months, the central bank “could take a step down” in its massive bond-buying program. Financial markets reacted furiously in what quickly became known as a “taper tantrum,” as prices fell and rates spiked for a range of bonds.
When Professor Anil Kashyap, Michael Feroli of JPMorgan Chase, Kermit Schoenholtz of NYU Stern School of Business, and Hyun Song Shin of Princeton University examine the causes of the tantrum, they identify a threat to the financial system in an unlikely place—the world of buy-side bond funds. They presented their findings at the 2014 US Monetary Policy Forum, sponsored by the Initiative on Global Markets.
As the Fed seeks to avoid a repeat of the recent US financial crisis, Kashyap and his colleagues argue that it should consider long-only bond investors who are not in danger of catastrophic failure but whose actions could lead to abrupt increases in interest rates.
The researchers find that bond markets typically exhibit a feedback loop in which investors pulling their money from bond funds cause those funds to sell assets, which drives up interest rates. The falling bond prices drive more investors to pull their money, causing more selling and further rate increases.
“Our results suggest that bond markets could experience another tantrum—along the lines of what was seen during the summer of 2013—as extraordinary monetary accommodation in the United States is withdrawn,” the authors write.
The tantrum was short-lived, but the authors warn easy recovery need not be the rule. “Overall stress in the system was lower than normal during the spring and summer of 2013, helping to cushion the impact of disturbances in the fixed-income markets,” the researchers observe, noting that economic growth had hit postcrisis highs in those months.
Any mention of tapering has continued to shake the markets. In December 2013, when the Fed next announced that it would taper its bond buying, the bank was careful to sound upbeat and to signal that the overnight lending rate would not creep up any time soon. Even so, investors yanked money out of emerging-market debt funds, causing rate spikes that affected countries such as India.
While the researchers are not suggesting that the Fed has done anything wrong or that it should cater to the sentiments of certain bond investors, they believe it should take into account the possibility that the end of its bond-buying program and zero-interest-rate policy could, if other stresses converge, prompt a large market setback that damages the economy. Rising bond yields, for example, could slow economic activity, leading to slower job growth, stagnant or falling wages, and diminished spending.
The Fed has fewer levers to pull in the bond markets than it does with leveraged banks. The Fed cannot force bond investors to sit tight in their funds, nor can it stop bond-fund managers from selling to meet redemptions. So, the Fed has to rely on conventional monetary policy and on its statements to limit the potential for tantrums. Kashyap and his colleagues have found another minefield for current Fed Chairman Janet Yellen and the Board of Governors to navigate.