Following the latest Federal Open Market Committee meeting, the Federal Reserve (Fed) indicated it is moving closer to slowing down, or ‘tapering’, its bond purchase program (which currently stands at $120bn [£86.7bn] per month). Our expectation is for tapering to begin in early-2022 and take around a year to reach zero. This move follows progress towards the US central bank’s goals of full employment and 2% average inflation.
The current bond purchase program, a form of quantitative easing (QE), was announced in March 2020 with the goal to “sustain smooth market functioning and help foster accommodative financial conditions” in the midst of the Covid-19 pandemic. This emergency monetary stimulus has so far led to the Fed’s balance sheet to almost double to $8.trn, or 37.2% of US GDP.
Source: Federal Reserve
The last time tapering occurred was in January 2014, following a two-year $85bn per-month bond purchase programme referred to as “QE3”. When plans for tapering were publicised by then Fed Chair Ben Bernanke in June 2013, investors swiftly withdrew money from bond markets in fear that Treasuries would become unstable without the Fed purchases. This led to a significant rise in bond yields, with the 10-year US Treasury yield almost doubling from 1.63% to 3.0% over the ensuing 12 months.
The market ‘tantrum’ included some stock market weakness too and resulted in the Fed announcing in September 2013 that it would delay its tapering. The Fed was able to finally begin slowing its purchases in January 2014 and stopped them completely in October 2014. Arguably, bond yields had risen in fear of the taper, but its reality turned out to be less significant and bond yields soon corrected back to where they were pre-tantrum.
Source: Bloomberg
If the Fed begins tapering in Q1 2022, will bond yields react in the same way as in 2013?
We think not as there are a number of differences in the circumstances of today compared to 2013.
Firstly, the Fed should be more aware of the market impact of tapering discussions and will therefore be more careful in its communication than it was in 2013. Secondly, current bond purchases are a smaller share of total issuance than they were in 2013, so we would not expect the same level of panic from markets.
Finally, this summer has been very different to 2013. Even as the economy has shown signs of normalising, the 10-year yield has fallen from 1.74% at the end of March to a low of 1.17% on August 3rd. Some of this reflects the fact that interest rate policy expectations are better anchored today than in 2013, with the Fed’s adoption of average inflation targeting offering more flexibility to be patient with future rate hikes.
While another tantrum seems unlikely, the extent of this ‘shoulder shrug’ by markets to the prospect of tapering in coming months feels overdone…
In contrast to the unwinding of QE3 in 2014, we expect yields to make a controlled move higher as we approach 2022. The US Treasury announced on 3 August that it expects net new issuance of $1,376bn in the second half of 2021. At its current rate of bond purchases, the Fed will buy $720bn of that, leaving the market to soak up ‘only’ $656bn, a quantum higher than it has had to for many years. If the Fed tapers in H2 2021 that will add even more to what the market needs to absorb and put upward supply/demand pressure on yields.
Additionally, real yields are at record lows as the market has ignored the increase in headline inflation to 5.4% in June. The market has completely bought into the Fed’s argument that inflation is “transitory”.
Source: Bloomberg
However, the combination of the strong recovery in economic growth, labour markets continuing to tighten and inflation surprising to the upside are all pre-conditions for the start of policy normalisation. We are concerned that this is not currently being reflected in bond markets.
Consequently, we are positioning both the Waverton Global Strategic Bond fund and Waverton Sterling Bond fund with a low relative duration stance. This should enable us to preserve capital if bond yields do, as we expect, correct higher in the coming months.
James Carter is a portfolio manager at Waverton Investment Management. The views expressed above are his own and should not be taken as investment advice.