New York/Washington.  While Wall Street frets over the ability of bond markets to absorb an approaching interest rate rise, the US Federal Reserve has a message for the industry: deal with it.

The financial industry worries that when the Fed’s tightening plans take hold, a sell-off in the massive US bond market could ensue, and be exacerbated by a lack of bank buyers willing to jump in.

Banks, including primary dealers who act as market makers for US Treasuries, have slashed bond inventories in the past few years in response to tougher capital requirements, reducing a liquidity buffer for the fixed income market.

Private and public comments by Fed officials show that they do not share Wall Street’s degree of concern about liquidity, and do not believe that capital rules are solely to blame for the bond market’s growing tendency to seize up.

Effectively, regulators are telling the industry it is the responsibility of banks, funds and other market players to protect themselves.

“It’s hard to find any financial market player who doesn’t talk about being concerned about potential liquidity issues,” Eric Rosengren, president of the Boston Fed, which oversees many of the country’s largest asset managers, told Reuters.

“So it would surprise me if I found that people were using a particular model and didn’t use any intuition about what goes into those models, and what might happen if everybody blindly uses those models.”

At last week’s congressional hearings, Fed Chair Janet Yellen resisted pressure by Republicans to acknowledge that new capital rules were destabilizing markets.

“You see this decline in liquidity in some measures, but not others,” she told senators on Thursday.

The Fed’s assertive stance is setting the stage for more volatile fixed income markets and where liquidity droughts could be the price of doing business in bond markets.

The message – in public addresses, reports to Congress, and even an investigation into market turmoil last October – is that less liquidity is a necessary consequence of regulatory reform and fitting for an economy that is getting ready for tighter monetary policy.

Investors cite many causes of market vulnerability: primary dealers holding far fewer bonds and the Fed holding far more; bans on some broker proprietary trading; a growing reliance on high-frequency trading; worries that funds will not have enough assets to withstand a firesale by clients; and rising volatility, especially in the emerging markets that could see big selloffs when the Fed hikes rates.

Overall US bond market volatility has risen 60 percent since a mid-2014 low, according to Bank of America Merrill Lynch’s MOVE index, which measures the implied volatility of US Treasury markets – a statistic that underscores liquidity concerns.

BlackRock, the world’s largest asset manager, has suggested it was time to move on and start devising strategies on trading through the dry patches rather than keep pushing back against tougher regulation.

Rougher seas

“There’s plenty of capital there. We need to talk about how that needs to move from holder to holder,” Richard Prager, BlackRock’s global head of trading and capital markets told a financial forum in May. “We clearly have a liquidity challenge at the moment but we have to recognize the journey and talk about what needs to be done.”

Three Fed governors have recently downplayed regulators’ role on the new dynamic taking over the bond market.

On July 15, the Fed reiterated that stance in its bi-annual monetary policy report to Congress, when the central bank said it did not see significant deterioration of liquidity in either the Treasury or the corporate bond market.

US Treasuries are the easiest debt security to trade globally, with the spread between bid and ask prices less than a hundredth of a percent.

But for 12 minutes on Oct. 15, sellers backed away, causing a wild price swing that sent the yield on the 10-year Treasury up by 0.16 percent and then down again.

In a report on the incident published last week, the Fed and other regulators found no single cause, while pledging to review firms’ risk-management strategies and monitor liquidity in the market.

What the Fed seems to be telling money managers is that they should be aware of a possibility of panic selling and a lack of buyers if all of them following similar risk models.

“I think they want to know that we are thinking about it and addressing it and I think now we all are,” an executive at an asset management firm, who requested anonymity.

Reuters

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This June 19, 2013 file photo shows the seal of the Federal Reserve Board of Governors in Washington, DC. (AFP Photo)

New York/Washington. Efforts to fill top positions at some US Federal Reserve regional branches are casting a spotlight on a decades-old process that critics say is opaque, favors insiders, and is ripe for reform.

Patrick Harker took the reins as president of the Philadelphia Fed this week, in an appointment that attracted scrutiny because he served on the committee of directors that interviewed other prospective candidates for the job he ultimately took.

The Dallas Fed has been without a permanent president for more than three months as that search process stretches well into its eighth month. And the Fed’s Minneapolis branch abruptly announced the departure of its leader, Narayana Kocherlakota, more than a year before he was due to go, with no replacement named to date.

The delays and reliance on Fed employees in picking regional Fed presidents can only embolden Republican Senator Richard Shelby to push harder for a makeover of the central bank’s structure, which has changed little in its 101 years.

A bill passed in May by the Senate Banking Committee that Shelby chairs would strip the New York Fed’s board of its power to appoint its presidents. And it could go further, given the bill would form a committee to consider a wholesale overhaul of the Fed’s structure of 12 districts, which has not changed through the decades of shifting US populations and an evolving economy.

The bill is part of a broader conservative effort to expose the central bank to more oversight, and some analysts saw the Philadelphia Fed’s choice as reinforcing the view that the Fed needs to open up more to outsiders.

Nine of 11 current regional presidents came from within the Fed, a proportion that has edged up over time. Twenty years ago, seven of 12 were insiders.

“The process seems to create a diverse set of candidates in which the insider is almost always accepted,” said Aaron Klein, director of a financial regulatory reform effort at the Bipartisan Policy Center.

Since it was created in 1913, the central bank’s decentralized structure was meant to check the power of Washington, where seven Fed governors with permanent votes on policy are appointed by the White House and approved by the Senate.

The 12 Fed presidents who are picked by their regional boards usually vote on policy every two or three years, and they tend to hold more diverse views.

Former Richmond Fed President Alfred Broaddus told Reuters the regional Fed chiefs have more freedom “to do and say things that may not be politically popular” because they are not politically appointed. “On the other hand, there is the question of legitimacy since they are appointed by local boards who are not elected.”

“Tone deaf”

Two-thirds of regional Fed directors are selected by local bankers, while the rest are appointed by the Fed’s Board of Governors in Washington.

Critics question how well those regional boards — mostly made of the heads of corporations and industry groups meant to represent the public — fulfill their mission.

Last year, a non-profit group representing labor unions and community leaders organized by the Center for Popular Democracy, urged the Fed’s Philadelphia and Dallas branches to make the selection of their presidents more transparent and to include a member of the public in the effort.

Philadelphia’s Fed in particular proved “tone deaf” in its head-hunting effort, said Lou Crandall, chief economist at Wrightson ICAP in Jersey City, New Jersey.

Harker was a Philadelphia Fed director when the board started looking to replace president Charles Plosser, who left on March 1, and he was among the six directors who interviewed more than a dozen short-listed candidates for the job, according to the Philadelphia Fed.

But on Feb. 18, Harker floated his own name, recused himself from the process and a week later his colleagues on the board unanimously appointed him as the new president.

While the selection follows Fed guidelines and was approved by its Board of Governors, it raised questions of transparency and fairness.

“The Philadelphia Fed’s search process might have made perfect sense in a corporate environment, but is obviously problematic for an official institution,” said Crandall.

The board’s chair and vice chair, Swathmore Group founder James Nevels and Michael Angelakis of Comcast Corp, respectively, declined to comment, as did Harker.

Peter Conti-Brown, an academic fellow at Stanford Law School’s Rock Center for Corporate Governance, and an expert witness at a Senate Banking Committee hearing this year, proposed to let the Fed Board appoint and fire regional Fed presidents or at least have a say in the selection process.

In the past, reform proposals for the 12 regional Fed banks have focused on decreasing or increasing their number and their governance.

Changes to the way the regional Fed bosses are chosen could strengthen the influence of lawmakers at the expense of regional interests.

For now, delays in appointments of new chiefs force regional banks to send relatively unknown deputies to debate monetary policy at meetings in Washington, as Dallas and Philadelphia did last month when the Fed considered raising interest rates for the first time in nearly a decade.

The Minneapolis Fed still has time to find a new president before Kocherlakota steps down at year end.

“For now the Fed criticism is just noise, mostly from Republicans,” said Greg Valliere, chief political strategist at Potomac Research Group. “But once the Fed begins to raise interest rates … then the left will weigh in as well.”

Reuters

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