Market structure and the rate rise Michael Cloherty of RBC Capital Markets makes an interesting point in a short note today about the role played by market structure in pushing interest rates higher than the Fed expected when Bernanke telegraphed the eventual tapering strategy. Yes, Cloherty writes, markets might have overreacted - but they are more jittery than in normal times because financial markets have increased their sensitivity to reabsorbing credit risk: Pre-crisis, there were certain shock-absorbers when market sentiment shifted sharply. When large sales caused MBS to cheapen, the GSEs would be massive buyers - effectively that trade would transform some of the interest rate shock into increased credit risk at Fannie and Freddie. And dealers would quickly absorb large amounts of paper and redistribute it over a longer, less jarring time frame - the same reduced market risk/inflated credit risk tradeoff was happening. Today, the clamping down on local credit risks to limit the damage seen in 2008 means the market does not have the same capacity to absorb shocks. The GSEs need to shrink their portfolios 15% per year, so they are no longer dip-buyers. The dealer community does not have the same aggregate balance sheet or risk tolerance, etc. So what starts as rate risk tends to stay as rate risk. This means we are likely to remain prone to overshooting, particularly when trades are crowded enough to be large relative to dealers" capacity to redistribute the risk efficiently. ... The Fed will need to be very gentle in the early phases of tightening, as none of us know if any structural weaknesses will have developed after nearly seven years at zero rates. It's true that regulatory changes and the interminable hangover from the crisis are (at least) partly responsible for the tight credit conditions imposed by some financial institutions. This shouldn't be ignored by policymakers, and in fact one of the Fed's jobs is to supervise some of these institutions to make sure they don't become a systemic risk. But from the perspective of monetary policy and the consequences of last week's FOMC meeting, the realities described above should function more as explanation than as valid excuse. Yes, there are structural issues that contributed to rates likely overshooting. But appropriate demand-side policy can help either neutralise these issues or set the conditions under which they can be more easily sorted. If the economy is on sounder footing, or is expected to return there, markets won't gyrate wildly to potential rate rises because credit risk will be less threatening. But it's hard to be confident of that when the Fed is sending muddled signals about its intent and fiscal policy is actively pushing in the wrong direction. And the aftermath of last week's FOMC meeting suggests that a premature signal of future tightening resulted in current tightening. The Fed's eventual exit will be complicated, but we continue to think that the logistical problems will be solvable; what matters is getting the timing right. Which is just another way of saying that what matters is getting the policy right.