What is tapering?
During the pandemic, several central banks restarted so-called quantitative easing (QE) programmes, through which they sought to stabilize financial markets and support economies by buying large quantities of financial assets, typically government bonds. For QE programmes that are open-ended (i.e., they have no fixed end date) such as that of the US Federal Reserve, tapering refers to the process by which monthly asset purchases are scaled back and ultimately stopped altogether.
Why is tapering making the headlines now?
Tapering is a hot topic at the moment because the US Fed – the most influential central bank in the world – has indicated that it will soon start to dial back its asset purchases. In September, Fed Chairman Jerome Powell indicated that the Fed could start to reduce its QE bond purchases as soon as November, and finish them altogether by mid-2022.1 The Fed is currently buying US$120 billion worth of bonds (US$80 billion of US Treasuries and US$40 billion of mortgage-backed securities) and the minutes from the Fed’s September meeting indicate that once tapering gets underway, purchases could be reduced by US$15 billion a month 2.
Why is this of concern to investors?
The Fed’s QE programme, along with those of other central banks, has played a key role in keeping government bond yields low and encouraging capital flows into more risky assets such as corporate bonds and equities. In turn, elevated asset prices are in part justified by the assumption that long-term bond yields will remain low for an extended period. Investors are concerned that the withdrawal of QE could result in a reduction in liquidity and/or a rise in bond yields which could trigger falls in equity markets. Recent surveys of global fund managers cite a repeat of the 2013 ‘taper tantrum’ as a key risk facing financial markets going forward 3.
What was the “taper tantrum”?
The taper tantrum refers to an episode which occurred the last time the Fed was conducting an open-ended QE programme, so-called QE3, which ran between September 2012 and October 2014. In May 2013, then Fed Chair Ben Bernanke triggered a period of sharply rising bond yields when he surprised the markets by indicating that the central bank could soon start to wind down its bond purchases. In the months after Bernanke’s comments, the yield on the 10-year US Treasury bond – a key benchmark rate for global financial markets - rose by about 100 basis points, ending the year around 3% 4. US equity markets fell back, albeit briefly, while emerging markets experienced capital outflows and saw their currencies come under pressure.
Has a taper tantrum been avoided this time around?
So far, it would appear so. The yield on the 10-year US Treasury bond has risen markedly from the pandemic lows of around 0.6%. However, this has largely been due to the upturn in economic growth and inflation over the last year or so. Since the Fed started talking about tapering over the summer, the US 10-year yield has traded in a relatively tight range of 1.2% to 1.6% (the current level is 1.59%) 5. The lack of a tantrum so far is in part a result of better communication from the Fed, which has learnt the lesson from 2013 and gradually prepared the markets for its tapering decision.
What does tapering tell us about the timing of future rate hikes?
Central bankers are keen to point out that tapering does not represent a tightening of monetary policy. Rather, it means that stimulus is being added at a slower rate. The Fed has indicated that a rate hike is unlikely before asset purchases are completed, and has tried to weaken the ‘signalling’ effect that tapering might have on interest rate expectations. In a speech in August, Fed Chair Powell noted that “The timing and pace of the coming reduction in asset purchases will not be intended to carry a direct signal regarding the timing of interest rate lift off, for which we have articulated a different and substantially more stringent test” 6.
This ‘decoupling’ of tapering and the timing of rate hikes is one reason why this year’s market reaction to the prospect of reduced bond purchases has been relatively muted. In contrast, the 2013 ‘taper tantrum’ was in part attributable to the markets rapidly bringing forward expectations for the timing of rate increases. In recent weeks, markets have moved to price in a rate hike for the second half of 2022 as Fed officials have become more hawkish 7, but the process has been relatively orderly.
Does tapering mean that bond yields are set to rise during the coming months?
All else being equal, lower purchases of bonds by the Fed should put downward pressure on bond prices and raise yields (the yield of a bond moves inversely with its price). The complicating factor, of course, is that ‘all else’ is rarely equal. Long-term bond yields are determined by a range of factors, including expectations for growth, inflation and the path of interest rates.
Somewhat counterintuitively, the US 10-year bond yield actually fell back during the period when the Fed last tapered its asset purchases between December 2013 and October 2014 8. Indeed, more generally, yields have tended to drop when periods of QE end, as the withdrawal of stimulus prompts investors to pare back expectations for growth and inflation. Going forward, this suggests that the incoming macroeconomic data and developments regarding President Biden’s infrastructure plans are likely to have a bigger impact on the direction of bond yields during the coming months than the direct effect of tapering per se.
There is also the issue of whether it is the stock of QE bond holdings or the flow of monthly purchases that is more important in keeping bond yields low. The prevailing view is that it is the size of the central bank balance sheet that matters most, with studies suggesting that the Fed’s stock of QE purchases has reduced long-term US yields by around two percentage points. Moreover, with longer-term US Treasury yields trading over one percentage point higher than their equivalents in the eurozone and Japan 9, demand from overseas investors is likely to help keep a lid on US yields during the coming months. Although bond yields appear too low relative to the strength of the economy, several factors are likely to work against a sharp rise as the Fed dials back its purchases during the coming months. Real (i.e., after inflation) yields could edge higher, but are likely to remain negative.
Does tapering threaten the bull market in equities?
Less generous liquidity provision as central banks dial back their asset purchases will result in a less potent tailwind for equity markets going forward. However, the prospect of US rate hikes and an absolute reduction in the size of the Fed’s balance sheet (i.e., the outright selling of bonds, or so-called Quantitative Tightening) are still some way off. In short, we are a long way from monetary policy becoming tight.
Moreover, it is important to remember that a key reason the Fed is withdrawing stimulus is because it sees a relatively strong economic outlook (policymakers see real GDP growth of nearly 4% in 2022 10). Consequently, continued earnings growth should be supportive of equity markets. Furthermore, the tapering process and Fed policy more generally are likely to be data-dependent, with the result that asset purchases could be adjusted if the economy fails to perform as policymakers expect.
It is worth noting that US equities posted strong gains during the previous tapering period and subsequent termination of QE3. During 2014, the iShares S&P500 ETF posted gains of just over 11% 11. The composition of the US equity market has changed a lot over the last 8 years; the big tech companies (the so called FAANGM stocks) now account for 25% of the US market compared with about 9% back then 12. As these growth stocks are more susceptible to rising yields, pressure on valuations could mount if bond market volatility increases as the Fed steps back. There is also a risk that persistent inflation prompts the Fed to withdraw stimulus more quickly than currently anticipated.
Against this backdrop, it would not be surprising to see markets get choppier as the Fed and other central banks dial back stimulus. However, equities are likely to remain attractive relative to the negative real yields on offer from most developed market bonds, and the tapering path recently outlined by the Fed seems unlikely to derail the current equity bull market.
3. BofA Global Fund Manager Survey.
11. FE Analytics