Graph showing 10yr Bond Yield after tapering

What is Tapering and Why Is It Important?

You may have heard the term “tapering” if you’ve been following the news lately. The Federal Reserve (Fed) has many tools it can use to stimulate the economy, which includes purchasing bonds in the open markets. Tapering refers to the Fed cutting back on its bond purchases (i.e. “tapering down”). The term goes back to former Fed Chairman Ben Bernanke. He used the term “taper” in 2013 to inform the public that the Fed would be cutting back its asset purchases. Markets threw a fit and the “taper tantrum” was born. Nearly a decade later and we are at the precipice of another taper event.

What the Fed’s support looks like today

The Fed is currently buying $80bn and $40bn of Treasuries and agency (Freddie, Fannie, Ginnie) mortgage-backed securities each month, respectively. Both treasuries and mortgage-backed securities fall into the bond category. The Fed is effectively creating a new market and providing liquidity to the tune of $120bn/month when it steps in and snaps up these bonds. This is an incredibly powerful tool when the economy looks like its headed towards a recession. It was implemented first following the Great Recession and housing market collapse in 2008. It was revived in 2020 in response to the economic fallout from COVID.

Why their actions work

This intervention isn’t without its drawbacks. The Fed purchases increase the demand for bonds. The increased demand leads to an increase in bond prices. The increased price leads to a decrease in the bond yields, which is the amount of interest someone receives for owning the bond. (Bond prices and bond yields are inversely correlated. When one goes up the other goes down). This not only bumps up bond prices, but it also puts downward pressure on interest rates since yields are lower. Both are stimulative.

This bump up in price is nice in the short run – but what happens when the Fed starts to cut down on the number of bonds its purchasing? That takes away some of the demand for bonds. Theoretically, that should lead to a decrease in bond prices and an increase in yields. But that’s not what happened the last time we were here!

What tapering 1.0 looked like

Bond yields actually went down in 2013 when the Fed started to taper. Bond prices went up as the Fed cut back its purchase program. This is entirely counterintuitive and it caught many off guard.

Graph showing 10yr Bond Yield after tapering

Source: Bloomberg, using weekly data as of 7/30/2021. US Generic Govt 10 Yr (USGG10YR Index). Shaded areas represent the periods of quantitative easing.

Why did that happen? Because the Fed has a near-deified power to influence financial markets and the signals it puts out carry exceptional weight. Investors read its 2013 announcement to cut back as a signal that it would be less accommodative going forward. They saw it as confirmation of slower growth, increasing interest rates, and less inflation. This was enough to move investors out of risky equities and into the safety of bonds. In fact, demand for bonds increased so much that it more than offset the Fed’s tapering. Bond prices went up and yields went down even further.

Whether the Fed realized it or not, the tapering announcement amounted to them taking the punch bowl and leaving the party. Not a cool move by any stretch.

Tapering 2.0

Most analysts expect the impact of tapering to be much more modest this time around. Investors have lived through this once before and know what awaits them on the other side. The Fed has learned lessons as well. It has become more sensitive and far more adept at when and how it communicates its policies to the public. This combo may keep investors from running towards the exits.

Interest rates and bond yields are also far lower today than they were at the time of the last announcement in 2013. As a rule of thumb, the lower the relative return the less attractive an investment becomes. It’s hard to imagine investors clamoring for even less yield that is currently available. The Fed Funds rate is already being held between 0% and 0.25%.

TIPS (Treasury Inflation Protected Securities) may see a hit. The market for this asset has a historically low level of supply. So, when the Fed started buying it had an outsized impact on TIPS. The central bank now owns about 22% of the entire TIPS market! Scaling back here will almost certainly leave a mark.

The path forward

Tapering may chart a different course this time around. We could see bond prices drop and yields rise. Its possible for turmoil to take hold in treasury and agency mortgage-backed securities markets where Fed activity has been historic, but we don’t think that’s likely. The markets and Fed have danced this dance already. We think an increase in yields and steepening of the yield curve is the more likely scenario this time out.

 

The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but is intended to help manage risks and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax, or financial advice. Please consult a legal, tax, or financial professional for information specific to your individual situation.

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