Over the past month, there has been much speculation by financial market participants that the Federal Reserve is preparing to pare back or change the outright composition of its $120 billion in monthly asset purchases—$80 billion in treasuries and $40 billion in mortgage-backed securities—that have damped rates along the entire maturity spectrum as well as mortgage rates. The potential pulling back or altering the composition of the Fed’s accommodation to the economy via the financial channel will have an impact on interest rates that will directly affect what consumers pay for homes, autos and credit card interest.
Why do I keep hearing the phrase “taper tantrum”?
On May 22, 2013, then Fed Chair Ben Bernanke in an appearance before a Joint Economic Committee of the U.S. Congress indicated that at some future date the Federal Reserve would reduce the volume of its bond purchases that had tripled to a then high of nearly $3 trillion.
The simple idea that the Fed would begin to reduce the pace of asset purchases—a process known as tapering—sent a shockwave through financial markets at the time, resulting in bond yields racing higher and a tightening of financial conditions that continued through the end of the year. The U.S. 10-year yield raced from 2.03% on May 22 to 3.02% on December 31 of that year. All of this culminated in what financial market participants refer to as the “taper tantrum.”
This is why, during his press conference following the June 2021 FOMC meeting, Fed Chair Jerome Powell carefully took the opportunity to address the idea of tapering, and by extension, another possible taper tantrum, by saying that when the Fed introduces the idea of reducing the pace of monetary accommodation it will do so in a gradual, methodical and transparent fashion. In essence, the Fed is signaling to the public and professional investors that we have reached the end of the beginning of our pandemic-era crisis response and that when the economy has made substantial progress on the central bank’s policy goals—reaching full employment and pre-pandemic levels of economic activity—we will begin pulling back on the pace and perhaps the composition of that financial support.
So will this tapering happen later this year when the Fed begins in earnest to lay out its roadmap for reducing the pace of the accommodative polices it put in place during the worst of the pandemic? We do not think so, but a little more information is required to understand why this is a serious risk to asset prices across financial markets.
Monetary policy in the modern era
The Federal Reserve has stressed two distinct policies in the post-financial crisis era: its interest-rate policy of maintaining liquidity in the money markets via its overnight policy rate; and facilitating investment and economic growth by pressuring long-term interest rates lower. The latter is accomplished via purchases of Treasury bonds and government-backed mortgage securities, which is known as “quantitative easing”.
Quantitative easing has arguably become a permanent part of the financial market landscape. It went through two phases immediately after the 2008-09 crisis, and then a third episode beginning in 2013, after financial commentators latched onto the idea that the Fed was considering winding down its purchases.
Even though in our estimation the unemployment rate was still too high and the inflation rate was still too low in 2013 to slow the pace of asset purchases, or quantitative easing, the Fed was determined to start the pace of monetary normalization. To investors, if the Fed was reducing its intervention into the bond market, then the demand for bonds would drop, ending the bull market. Thus, the infamous “taper tantrum” was born.
The unintended consequence—following the tightening of financial conditions, rising interest rates and volatility in equity markets—was, of course, a third wave of bond purchases by the Fed and a resumption of a jagged bear market in bonds. That lasted until the latter half of 2016 when that year’s election became a factor.
Bond yields were in decline from 2019 until the depths of the pandemic, and there wasn’t much room to drop further without heading into uncharted territory of negative long-term interest rates. So the 125-basis-point increase in bond yields since 2020 should be construed as a sign of a healthier economy. The more recent 25-basis-point decrease in 10-year yields suggests market recognition that there is still a long way to go and that the Fed will be consistent in its policies.
So what is the probability of another taper tantrum? We think the likelihood of another such episode is low, given the Fed’s transparent signaling of the coming reduction in the pace of asset purchases.
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