The tapering headache

No one was expecting fireworks from the Jackson Hole symposium in August, and they didn’t get any. The message from US Federal Reserve (the Fed) chair, Jerome Powell, was more or less the same – it’s time to ease back the throttle on bond purchases. Tapering bond purchases is just the first step in the long journey of policy normalisation but it’s not likely to be one that trips the markets.  

Powell couldn’t front run the rest of the rate setting committee at the Fed by signalling something that wasn’t already agreed. But what he did do was solidify the consensus view that tapering would begin this year. More importantly, he separated the Fed’s views on drawing quantitative easing to a close from how it views the path for interest rates. 

The Fed is not the first to start down this path, but it is the most important one. The Reserve Bank of Australia (RBA) has already outlined its very flexible approach to reducing bond purchases, the Bank of Canada began its tapering months ago, meanwhile the Bank of Korea recently became the first major emerging market central bank to raise interest rates. However, the Fed’s actions are more significant given it will impact the risk-free rate against which nearly all the world’s assets are measured. 
September is the next opportunity for the Fed to reinforce its messaging and provide greater clarity to markets about what to expect. However, this may not be the meeting where tapering is formally announced. Waiting until later in the year, most likely November, means a couple more months to be sure the US economy is on the right path, as well as clarity on the potential impact of further fiscal stimulus. 

One of the most significant changes from the COVID-19 experience has been the marriage of monetary and fiscal policy and the willingness of governments to pursue expansive monetary policy, even as the economic outlook improves. In the US, the US$1.2 trillion ($1.6 trillion)infrastructure spending bill and a US$3.5 trillion bill aimed at boosting social initiatives are slowly making their way through Congress. The funding of this spending will be split between changes to corporate and individual taxes as well as increases to the government deficit. But the net effect – if the bills pass as planned – will be positive for the US economy. 

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The taper itself may be rather mechanical once it begins, given the lead time to prepare markets for the change and the uncertainty that could be created in communicating changes. With details pending, the most important aspect is whether the pace of reduction is palatable to the market. Reducing bond purchases by US$12 billion to US$15 billion per month seems broadly acceptable. 

It’s important to note that when the Fed does start tapering, it isn’t withdrawing liquidity from the system, it’s just adding it at a slower pace. Assuming that the Fed reduces bond purchases by US$12 billion to US$15 billion per month starting in January next year, this still means that the Fed will purchase between US$420 billion and US$540 billion in Treasuries and mortgage-backed securities in 2022. Even when quantitative easing comes to an end, the Fed will still be purchasing bonds to ensure that its balance sheet doesn’t shrink.

Once the taper starts, attention will quickly turn to what is likely to happen when it ends. Two questions in particular will matter: whether the US economy will be in the right state to raise interest rates, and can the Fed really raise interest rates more than just a few times before the economy runs out of steam.

The answer to the first question is a resounding yes. When the Fed embarked on its last tightening cycle in 2015, the economy was in good shape, but things are stronger today, thanks to a government willing to spend to boost the recovery. In 2015, the unemployment rate averaged 5.3%, inflation averaged 1.3% (as measured by the core personal consumption expenditure (PCE) deflator, the Fed’s preferred measure) and economic growth was 2.7% for the full year. Looking at J.P. Morgan’s forecasts for the US economy for 2022, the unemployment rate is expected to be 4.4%, inflation 2.8% and growth at 3.9% for the full year.

The answer to the second question is more ambiguous. The Fed’s long-run projection for the interest rate is 2.5%, a similar level it got to in its last rate hike cycle. But this view may be clouded by debt sustainability issues given the significant increase in federal debt that needs to be financed, as well as what to do with its balance sheet. 

The Bank of England (BOE) laid out its approach recently. The BOE’s plan is that once the cash rate reaches 0.5% (currently 0.1%), it will allow for the natural attrition of its balance sheet by not replacing bonds as they mature. All going well, the BOE will keep raising the cash rate and once it reaches 1.0% it may become more active in actually shrinking its balance sheet. 

This approach places more emphasis on balance sheet reduction than on a higher cash rate and implies that asset purchases, rather than rate cuts, may be the focus of future policy support, hence the need to lower the balance sheet in preparation. The Fed may not feel the same way, but will need to prepare to use this policy tool again at some point in the future. 

There is a risk that the additional fiscal stimulus, at a time when the economy is recovering, generates higher than expected inflation before the tapering process ends. It raises the question of how the Fed, or any other central bank, would be able to raise interest rates while still purchasing bonds. This explains why central bankers appear to be pursuing these exit strategies even as the economic momentum has waned in the last few months. 

What does all this mean for markets? History isn’t a perfect guide but we can draw a few lessons from the 2013 tapering experience. The first is that the Fed has spent a great deal more time in preparing the market for the gradual reduction in bond purchases and is overall a more dovish institution than the one headed by the then Fed chair, Ben Bernanke. This reinforces the gradual nature of both the tapering and eventual rise in interest rates. 

Next is that tapering didn’t end the equity bull market. The Fed started to taper its bond purchases in December 2013, the US S&P 500 rose by 13.7% in 2014, the MSCI Asia ex Japan by 7.7% and European equities by 5.2% (total returns in local currency). For fixed income, policy normalisation did not lead to higher US government bond yields. In fact, contrary to expectations, the 10-year Treasury yield fell from 3.0% to 2.2% over the course of the year. This benefited US government bonds and investment grade corporate debt, which have longer durations and perform better as yields fall. 

Nonetheless expecting a copy and paste of the 2014 taper may be less than wise. The Fed’s policy setting is important for investors, but it is only one of many factors determining asset allocation in the months ahead. Valuations are also a crucial factor. The S&P 500 is trading at a price to forward earnings multiple of 21.2x and the ASX 200 at 18.0x whereas, back in 2014, markets looked a lot cheaper at 16.0x and 14.8x respectively. The full re-opening of many sectors and economies is supportive of the earnings outlook and helps to maintain lofty multiples, it’s unlikely to drive them higher and put a lid on returns. 

Yields on core government bonds are unlikely to fall this time around. In 2013, bond markets were quick to reprice the impact of tapering before it began and upside risk to the inflation outlook was not part of the bond market calculus. 

When my wife was pregnant with our first child, we were given the book 'What to expect when you're expecting' to prepare us for parenthood. No matter how much information was gleaned from this book, at best it was a loose guideline to what may happen but not every eventuality. 

There is an expectation that the Fed will soon announce the beginning of the end for quantitative easing and the gradual path back to ‘normal’ policy settings. We know that this is unlikely to create a bear market or sudden collapse in economic activity, but there are some wildcards around the potential for higher rates of inflation and uncertainty of COVID-19 that will still need to be managed.  

Kerry Craig is global market strategist at J.P. Morgan Asset Management.