Content Provided by Marc Pfeffer, CLS Senior Portfolio Manager

As someone who has played poker for a long time, one of the most important attributes to winning is to read or “tell” your opponents. A “tell” can be a comment, gesture, or facial expression. Something that alerts you to how strong the opponent’s hand is, or whether they are bluffing.

During my 25-year tenure, I’ve found many similarities between managing fixed income/money market assets and playing poker. Dissecting economic data and Fed speeches to try and determine the “tells” as to when interest rates may change, has been an important tool to properly set up portfolios. For the past several years, the Federal Reserve has been keeping short-term interest rates at 0, with the “plan” to remain that way until sometime in 2015. Recently, the committee decided to focus on the unemployment rate to decide when to pull that lever. However, the risk-taking in many credit markets bring back similarities to how we got here in the first place.

A financial blogger I follow, Ryan Mcarthy, wrote:

Should the Fed try to use interest rates to control not just inflation and unemployment, but financial markets too?

In a speech earlier this week, Fed governor Jeremy Stein pushed for the Fed to change the way it approaches overheated markets, arguing that the Fed should consider raising interest rates to prevent financial bubbles. Along the way, Stein warned that the market for junk bonds and REITs might be overheating.

Stein is honest about limitations of the Fed’s bubble-spotting abilities: “We should be humble,” he says, “about our ability to see the whole picture”. What’s more, even when Fed members do warn of possible bubbles, the Fed has been generally terrible at stopping them.

As Neil Irwin points out, the Fed has generally been opposed to avoid raising interest rates to stop bubbles, on the grounds that doing so is “the equivalent of fumigating an entire house after finding a small patch of mold”. Or, as Ben Bernanke said, surveying the economic consensus in 2011, “monetary policy is too blunt a tool to be routinely used to address possible financial imbalances”. Much better than raising rates, Bernanke said, is to use the Fed’s regulatory powers instead.

It makes me wonder, is the Fed giving us a “tell” now that they are more concerned with setting ourselves up again, only to return to the same mess we’ve worked almost five years to dig our way out of?

0449-CLS-2/14/2013