Record levels of government financial intervention have been necessary to support the US economy throughout the Covid-19 Pandemic. Much needed additional spending has come from borrowed money issued by the US Treasury. In an adjacent process, known as quantitative Easing (QE), the US Federal Reserve (The Fed) participate in the US bond market as a key buyer. By doing so they help drive bond yields lower than they might otherwise be. A lower yield on US bonds is stimulatory for the global economy and lowers the cost of debt for US taxpayers, encouraging spending domestically too. Moreover, by acting as a buyer the Fed are signalling, they want interest rates to remain low.
A key question to ask therefore is what will happen when the Fed stop buying bonds?
Before we attempt to answer this question, we need to set the scene. The latest round of QE began back in 2020. In July of that year, they started buying $120bn of bonds each month, across a range of maturities. However, the Fed reacted earlier in the process when in March they cut interest rates to zero helping head off stress building up bond markets in the early stages of the pandemic. Their prompt action helped inject liquidity and signalled to investors that the Fed ‘had their back’.
We can gauge the scale of their response by looking at the expansion of the Fed’s balance sheet -which is where they hold the debt purchased. The chart below shows they doubled their total assets, primarily consisting of Treasuries (government debt), but also dived into other areas of the debt market – primarily mortgage-backed securities.
Chart 1: US Debt and Total Fed Assets – July 2018 – July 2021
Source: Bloomberg, 27/08/2021
How Will Stopping Buying Affect Broader Markets?
The first point to make is that the Fed will not stop buying, they will slow their pace of purchases through a process known as tapering: They have already hinted that they may initially reduce the monthly amount by $20 Billion, but haven’t indicated when.
Another point to acknowledge is the Fed are only talking about tapering and have even said that they are ‘talking about talking about tapering’. They are aware that by signalling their intentions well in advance they will avoid upsetting the delicate balance that exists in bond markets; especially as inflation has been heating up, albeit deemed transitory. If they get the timing and the scaling back wrong investors could throw a tantrum. They stop buying.
What Happens if Investors Throw a Tantrum?
A reference point demonstrating how markets react to tapering is evident from what happened back in 2013. The then Fed Chair, Ben Bernanke, announced that as the economy was seeing continued improvement, they would “step down their pace of purchases [of government debt]”.
This came as a surprise and the US 10-Year Treasury note rose sharply from 1.62% to nearly 3% from April to September 2013. Equities were also impacted with the S&P 500 dropping by 5% in an event dubbed the “taper tantrum”. Simultaneously equity investors shifted their focus, rotating away from growth and cyclical sectors of the market moving towards value areas.
Chart 2: US 10 Year Treasury Note Yield – Apr 2013 – Sept 2013
Source: Bloomberg, 27/08/2021
What Lies Ahead?
This week the annual Jackson Hole symposium will be held ‘virtually’ for the second time. Central bankers, ministers, academics, and financial market participants are given the opportunity to question the current Fed chair Jay Powell.
However, economists are not expecting any great pronouncements about tapering at the meeting. According to Goldman Sachs details setting out tapering measures will be publicised in November at the earliest. They reason that uncertainty surrounding the Delta variant and vaccine hesitancy in some US states give sufficient justification for holding back tapering even though the Fed’s preconditions for doing so appear to be coming good i.e., price stability and maximum employment.
So those hoping that Jackson Hole will bring some clarity about the Feds stance and what circumstances would lead to tapering are thin on the ground. There is a chance, slim perhaps, that further discussion at the September Federal Open Markets Committee (FOMC) meeting will lead to an announcement.
Mind you Jackson Hole can spring surprises. Last year the Fed announced a dramatic shift in their policy and changing their stance on unemployment. The central bank Chair stated they would now aim to limit shortfalls from full employment rather than seeing excess employment as a problem to be solved. Also, indicating a willingness to tolerate higher inflation should circumstances warrant the need to accommodate rising prices.
Conclusions
Tapering is on the horizon, but timescales are uncertain.
The Fed have learned a lesson about tantrums and have decided to ensure the market is aware of its intentions – no surprises
Easing back on bond purchases is an acknowledgement the economy needs less central intervention and that it gradually moving back to being self-sustaining.
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