Crises around the world put a wrench in Fed plans

Crises around the world put a wrench in Fed plans

Investors’ flight to safety will eventually limit the Fed’s ability to normalize rates.

When the US announced new sanctions on Russian officials before Wall Street opened on July 17, most global markets dropped sharply, including the benchmark US bond rate. Just a few hours later, news broke that Malaysian Airlines Flight MH17 was shot down over eastern Ukraine and the yield on 10 Year Treasury Notes dropped sharply again.

The movement in US bond rates was no coincidence. Investors once again began a flight to safety just like they did during the Euro-crisis. In an unstable world, US Treasuries are one of the few things that comfort investors. At market close on July 17, 10 Year Treasury Note yields were at their lowest level of the last year, outside of when a bad German unemployment report rose concerns over European stagnation.

10 year treasury note yields

US 10 Year Treasury Note Yields on July 16-17. Yields dropped dramatically in response to negative news about the Ukrainian crisis (Source: Yahoo! Finance).

When investors move money out of international investments and return them to relatively safe US bonds, the price of those bonds increases, which causes the yield to drop, as occurred on July 17.

Geopolitical crises like the one in Ukraine rarely affect Federal Reserve policymaking, since its Congressional mandate is to manage US inflation and unemployment. The longer the Ukrainian crisis lasts, however, the more likely it will undermine Fed policy.

Returning to normalcy

Since it announced a gradual end to Quantitative Easing in December 2013, the Fed has pondered when its extremely accommodative policy can end without negatively affecting the US economy. Sometimes the internal debate has publicly divided the Federal Open Market Committee, but the consensus is that its first interest rate hike will occur in mid-2015.

Between now and then, US bond rates are believed to slowly rise from their historically low levels, especially once Quantitative Easing ends in October. By winding down easy money policies slowly, the Fed is aiming to give financial markets a smooth landing in moving rates back to their long-term averages.

More pressing than the temperament of financial markets is the risk of letting rates remain too low for too long, which some FOMC members already think has happened. This could allow financial markets to overhear and inflation to become high enough to damage the economy. Chairwoman Yellen has already expressed some concern about the former, and other members have been warning against the latter for year, even if their predictions have not come true.

Handcuffed by foreign crisis?

With the crises in Ukraine, Iraq, and other volatile regions sending investors on a flight to safety with US Treasury Notes, the Fed may have less control over how much rates rise. The risk associated with foreign markets will dampen Fed actions and drive US Treasury Note yields lower than they would be otherwise. Compared to a less volatile international scenario, US inflation and financial markets may be pushed higher to unhealthy levels.

Ironically, a consequence of the flight-to-safety may be an increase in risk-taking across US financial markets – albeit a different kind of risk. Historically low bond rates have increasingly led to a reach for yield over the last two years. Investors, especially in fixed income strategies that usually invest heavily on US bonds, have not been able to meet their promised returns with Treasury Notes anymore and have been forced to turn to other assets with higher returns but also higher risk.

A gradual ratcheting-up of risk taking was one goal of Fed policy over the last five years – but that was only to thaw frozen credit markets in the aftermath of the financial crisis. The Fed is now carefully trying to induce a healthy, but not excessive, amount of risk-taking, but a flight-to-safety keeping US Treasury rates artificially low will inhibit the Fed’s ability to manage a smooth landing to normal policy. Worst of all, geopolitical crisis is nearly impossible to forecast meaning the Fed will not be able to plan for it, even if it possessed a better forecasting track-record.

Categories: Economics, North America

About Author

Alex Christensen

Alex is an Editor at Global Risk Insights, who also currently works in investment research. His work on political risk and economic policy has appeared in many forums, including Business Insider, Seeking Alpha, & The Emerging Market Investors Association. He holds a Master’s in Economics from the London School of Economics and BA from Washington University in St. Louis.