A paper by Feroli, Kashyap, Schoneholtz and Shin illustrates how unlevered funds can become a source of asset price momentum due to peer pressure and redemptions. Regulatory reforms that impair bank intermediation could compound negative escalatory dynamics. This raises the risk of dislocations in fixed income markets if and when extraordinary monetary accommodation is being withdrawn.

“Market tantrums and monetary policy”, Michael Feroli, Anil Kashyap, Kermit Schoenholtz, and Hyun Song Shin, February 2014

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The below are excerpts from the paper. Emphasis and cursive text has been added.

“We highlight unlevered investors as the locus of potential financial instability and consider the monetary policy implications…Our focus is on market ‘tantrums’…in which risk premiums inherent in market interest rates fluctuate widely. Large jumps in risk premiums may arise if non-bank market participants are motivated, in part, by their relative performance ranking [and] redemptions.”

“We sketch an example and examine three empirical implications…[1] as a product of the performance race, flows into an investment opportunity drive up asset prices so that there is momentum in returns…[2] return chasing can reverse sharply…[3] changes in the stance of monetary policy can trigger heavy fund inflows and outflows.”

Why real money funds can throw market tantrums

“Textbook buy-side investors are assumed to stabilize markets, as they step in to buy when the price falls while selling when prices rise excessively, thereby cushioning shocks to financial markets. Instead… there is evidence that buy-side investor flows may amplify shocks in fixed income funds rather than dampen them. The evidence is that investors partially sell when the prices fall. Also, sales tend to elicit further price declines, so that price changes and sale volumes may lead to feedback loops that mimic the amplifying distress dynamics more familiar with banks.”

Delegated investors such as fund managers are concerned with their relative performance compared to their peers…One reason for this concern regarding relative performance may be that it affects their asset gathering capabilities…Although delegated agents are risk-neutral and care about the fundamental values of the assets, the element of relative ranking injects spillover effects. Because being ranked low is costly, each delegated agent tries to avoid underperformance relative to the group. However, the more others try to avoid underperforming, the harder any particular delegated agent must try to avoid the fate of underperforming…[Hence] we suppose that investing agents are averse to being the last one into a trade. Although this feature may sound innocuous, it can potentially set off a race among investors to join a sell-off in a race to avoid being left behind. The analogy is with a game of musical chairs.”

“The effects…would be even more potent if redemptions by claimholders on investment vehicles generate run-like incentives. Chen, Goldstein and Jiang (2010) provide evidence that redemptions from mutual funds holding illiquid assets create incentives like those facing depositors in a bank run…”

Regulatory reform could aggravate the consequences

“Ongoing regulatory developments could magnify the potential for spillover to the real economy from a future bout of market distress. The Dodd-Frank legislation, the Volcker Rule, higher capital standards, and elevated liquidity requirements all have altered the behavior of leading financial intermediaries compared to historical experience. As the Office of Financial Research noted in its 2013 Annual Report, dealer inventories of some fixed income securities have declined in recent years despite ongoing expansion in the overall size of these markets….The phase-in of these regulations will continue over the next few years, potentially reducing the ability for the dealer community to serve as a buffer during periods of market stress.”

Consequences for monetary policy

“Forward guidance encourages risk taking that can lead to risk reversals…financial instability need not be associated with the insolvency of financial institutions…the tradeoffs for monetary policy are more difficult than is sometimes portrayed. The tradeoff is not the contemporaneous one between more versus less policy stimulus today, but is better understood as an intertemporal tradeoff between more stimulus today at the expense of a more challenging and disruptive policy exit in the future.”

“While the purpose of tightening monetary policy is to slow the pace of economic activity, the type of instability generated by our model [of unlevered investor behavior] can lead to a nonlinear reaction in risk premium, making a “soft landing” more difficult to achieve. Thus, the potentially excessive real economy impact is genuine, even though no institutions fail, and no financial institutions are bailed out using public funds.”

“Even if the real economic consequences of market tantrums are smaller than those that arise from banking sector problems, market tantrums driven by non-banks cannot be addressed by the usual micro- and macroprudential policies. The absence of an alternative tool for addressing the problems tilts the burden of proof toward those who argue that market tantrums should not be factored into monetary policy considerations.”