S&P's Blitzer: Bond Prices Could Cascade Down on Fed Tightening
by John Morgan
October 21, 2014
The turmoil in the financial markets last week is a strong hint of things to come — including a potential rout in government bonds — when the Federal Reserve finally starts tightening rates, according to David Blitzer, chairman of the index committee at S&P Dow Jones Indices.
Blitzer said market free-falls sometimes have unexpected consequences.
"As downward momentum gains strength it persuades investors that they should be getting out. When that happens, investors want to sell the dogs — their least attractive unwanted and illiquid holdings," he wrote on the company's Indexology blog.
However, Blitzer noted the dogs are often the hardest things to sell when a market sells off in a big way, because that's when buyers become most are scarce for weaker issues.
"The response? Investors have no choice but to sell what they can sell, not what they want to sell. What can they sell in the midst of the storm? Anything in the deepest markets: either U.S. stocks or U.S. Treasurys."
When the Federal Open Market Committee announces a tightening of monetary policy, likely sometime next year, volatility will ensue, he predicted.
"Investors in a rush to sell unwanted bonds will find the only liquid market is 10-year Treasurys; they will be forced to keep junk bonds and sell, or short, Treasurys," Blitzer noted.
"Others simply looking for a hedge will also short treasuries. Those illiquid unwanted bonds will then be re-priced at lower levels consistent with the falling prices on over-sold U.S. Treasurys. Fixed income prices could cascade downward."
According to Josh Bivens, director of research and policy at the Economic Policy Institute, the majority of the Fed's voting board and regional presidents believe short-term interest rates should be hiked in 2015, and that recent stock declines are no reason to postpone the move.
"In short, even when you end up doing the right thing, you should do it for the right reason. And trying to stem stock market declines is the wrong reason for the Fed to act," he wrote in an article for The Wall Street Journal.
Bill Conerly, senior fellow at the National Center for Policy Analysis, wrote in a column for Forbes that a hike in interest rates will not worsen the federal deficit.
"There's actually a bit of an inverse correlation: higher interest rates imply lower deficits, Conerly said.
"And the Fed's mandate to keep inflation in check is critical to a healthy economy."