What is tapering and what the Fed will do
Discovering tapering. The analysis by Althea Spinozzi, senior fixed income strategist for BGSaxo
What does tapering mean?
When members of the Federal Reserve talk about tapering, they are referring to the gradual slowdown in large-scale asset purchases. Hence, it is about reducing the pace of expansion of the Fed's balance sheet, also known as Quantitative Easing (QE). The next step after tapering is to consider whether to reinvest the maturing securities or reduce its balance sheet. The central bank can decide whether to gradually reduce its balance sheet by letting maturing securities “run” without reinvesting them or whether to sell the assets.
What is Quantitative Easing (QE)?
QE refers to central bank asset purchase programs created to stimulate the economy. It is a form of monetary policy used to increase the internal supply of money and stimulate economic activity. Central banks resort to quantitative easing when the short-term interest rate plummets to zero, but the economy still needs support. The idea behind QE is that it helps the economy by reducing interest rates and making corporate loans and mortgages cheaper. By buying government debt and Mortgage-Backed Securities (MBS), central banks reduce the supply of these instruments in the market. Investors who decide to hold these instruments need to raise their bids, thereby pushing yields down. In the wake of the Covid pandemic, the Federal Reserve cut short-term interest rates to zero in March 2020. As of July 2021, the Federal Reserve bought $ 80 billion of US Treasuries and 40 billion MBS to stimulate the economy and ensure a rapid economic recovery.
Is QE different today than at other times in history?
Currently, the Fed is buying Treasuries across a wide range of maturities to mitigate the COVID-19 shock. In the past, however, QE was focused almost exclusively on long-term maturities. So today's tapering could have a different impact on the yield curve.
Why is the Federal Reserve trying to reduce the pace of asset purchases?
The simple answer to this question is: because the economy no longer needs stimulation. The US economy is estimated to grow an impressive 6% this year and 4% next year. At the same time, inflationary pressures and excessive risk taking in the markets have accelerated significantly making the end of QE a natural consequence. However, Jerome Powell recently pointed out that "substantial further progress" is needed to begin tapering. These observations can be linked to the full employment goal. The Fed looks at the pre-COVID unemployment rate, which was around 3.5% and has set it as a target but the risk in this case is that the economy will overheat and the QE program will continue to stimulate growth. of inflation.
What is a "taper tantrum"?
“Taper tantrum” refers to a particular incident that occurred in 2013. After three rounds of QE to stimulate the economy following the global financial crisis (GFC), then Fed Chairman Ben Bernanke decided to decrease purchases in May 2013. The following month, a tapering plan got underway. Yields rose from 2.2% to 3% over the summer, despite Bernanke and other Fed members stressing that any reduction would be gradual and not linked to any interest rate hikes.
The sudden rise in US treasury yields caused capital outflows and currency depreciation in emerging markets such as Brazil, India, Turkey and South Africa. Regardless, central banks started tapering in December of the same year, reducing the pace of asset purchases by $ 10 billion a month from $ 85 billion. The asset purchase program closed in October 2014. The Federal Reserve, led by Janet Yellen, began reducing stimulus a year later.
Could tapering in 2021 provoke another “taper tantrum”?
Compared to 2013, Jerome Powell has tried to decouple the tapering talks with interest rate hikes. In fact, he made it clear that tapering will precede any rate hike considerations. Also, tapering doesn't mean the Fed's balance sheet will shrink anytime soon. It will continue to grow (albeit at a slower pace) until the tapering ends, thus continuing to provide a stimulus to the economy. From this perspective, tapering shouldn't be a big game-changer for the bond market.
However, tapering gives a signal about the central bank's future political intentions, affecting long-term interest rates. Expectations of less accommodative policies may spur a sell-off in the long end of the yield curve before the Federal Reserve even begins contemplating reducing its balance sheet.
It is also important to point out that tapering could be introduced in the final quarter of the year, when we could see the reflation trade come back to life as growth and inflation continue to be sustained.
In conclusion, we may not run into a taper tantrum, as happened in 2013. However, the rise in yields could be explained by the macroeconomic situation and accelerated by the Fed's monetary policy intentions.
Why can reducing the size of the Fed's balance sheet be more problematic than tapering?
The reason lies in the fact that the increase in the supply of assets on the markets, in the face of a demand that remains unchanged, could cause an increase in yields, thus tightening economic conditions. Since the global financial crisis, the Federal Reserve has decided to slowly reduce its balance sheet only once from October 2017 to September 2019.
However, it didn't end well. In mid-September 2019, money market rates spiked due to the expiry of the corporate tax and the increased supply of US Treasuries. The Federal Reserve had to announce an overnight repo operation to add reserves to the system. A month later, the Fed had to reintroduce QE by buying Treasury bills at the rate of $ 60 billion a month. It continued to do so until the second quarter of 2020, when Covid arrived. Factor that forced the Fed to further intensify the stimulus measures.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/tapering-che-cos-e/ on Sat, 11 Sep 2021 06:00:23 +0000.