These days, all the talk in financial markets is about when the Federal Reserve will start paring its debt purchases. What’s more important, for everything from stocks to bonds to currencies, is when they will end.
There have been few major moves ahead of the Kansas Fed’s virtual Jackson Hole symposium, where Chair Jerome Powell on Aug 27 may provide insight into how and when officials will start pulling back their bond market support. That will set the timetable for how soon the Fed will raise interest rates.
The stakes are high, with the gusher of cash awash in the financial system driving US stocks to record highs, and Treasury yields holding just above six-month lows. Pulling back too quickly may derail the economic recovery just as the surge in the delta variant is posing a new risk. Moving too slowly could fuel the inflation pressures unleashed by the reopening from the pandemic.
“The key for markets is how quickly the Fed removes the accommodation, because that dictates how soon until we have none, which then translates into when the first rate hike comes,” said Tom Essaye, a former Merrill Lynch trader who founded The Sevens Report newsletter.
The Fed is currently buying US$80 billion ($108 billion) a month in Treasuries and US$40 billion of mortgage-backed securities, which the central bank is expected to wind down before it raises interest rates. It has said it will hold those purchases steady “until substantial further progress has been made toward its maximum employment and price stability goals”.
When the Fed unwound a similar US$85 billion-a-month programme in the aftermath of the last recession, it took 10 months. The reductions were announced in December 2013 and began the following month, with the central bank detailing cuts by US$10 billion at each policy-setting meeting, divided evenly between Treasuries and mortgage bonds. The Fed wrapped up all the buying in October 2014 and went on to raise rates in December 2015 after keeping them steady for seven years.
Essaye expects tapering to begin in December and finish around the end of 2022, which he said will help fuel more gains in stocks and commodities and send the 10- year yield climbing toward 2%.
Money-market traders are currently pricing in that the Fed will first increase rates in 1Q2023 — with the funds rate peaking at about 1.4%.
“When the Fed actually announces the taper, it will likely also give some degree of information on what pace it will take and how flexible or inflexible they want to be with the process,” said Guneet Dhingra, head of US interest-rate strategy at Morgan Stanley. “That could provide a key signal for the rate-hike cycle — particularly with regard to the pace of the hikes.”
Spread narrows
US 10-year yields have drifted steadily downward since March and are now around 1.34% amid concerns that the resurgent pandemic in the US will damp the recovery. The spread between long and short-term yields has also narrowed since hitting a more than five-year high in March, a sign of speculation that the Fed will start to withdraw its stimulus. The prospect of higher rates has boosted the dollar, driving the currency this month to its highest since November, according to the Bloomberg Dollar Spot Index.
Morgan Stanley forecasts that 10-year Treasury yields will end the year at 1.8%, with the Fed beginning to taper in January and ending in October. The firm predicts the Fed’s first rate hike will come in the second quarter of 2023.
Steven Barrow, Standard Bank Group’s head of G-10 strategy, said there is more risk if the Fed delays its tapering than if it moves too soon. He said a delay could force the central bank to raise rates within just months of ending its bond purchases, which could rattle financial markets and fuel a retreat from risk that would send investors into havens like the yen and the Swiss franc.
“It would be dangerous for the Fed to do this because it needs to be in a position — from the middle of next year — to start putting out the rhetoric that they maybe raising rates,” Barrow said. “And we know it’s not out of the realm of possibilities that the Fed could lift rates some time around the end of next year. So I’m focused more on the end point for Fed tapering than the starting point.”
Right conditions
The important thing about the Fed’s taper plan is not what the calendar dates will be, but whether or not it takes place when the economic conditions are right, according to Bloomberg Economics. If the Fed surprises with a taper when conditions are not right, activity and asset prices would take a hit, senior global economist Björn van Roye wrote in a research note.
St Louis Fed President James Bullard says he would like to see the tapering end by the first quarter of 2022. Atlanta Fed’s Raphael Bostic said it should start after a few more strong job reports and wrap up faster than in past episodes.
There is more at stake in normalisation this time around as the backdrop of near-zero rates and easing is joined by a historic debt overhang and near-record duration, indicating how sensitive the bond market is to changes in rates. That is a risk that extends into equities, even tech stocks that soared after the onset of the pandemic. The cheap money that has been plowed into markets globally, driving down bond yields, has stoked a search for yield that has raised signs of bubbles nearly everywhere.
“Liquidity on the margin is what matters in these markets,” said George Goncalves, head of US macro strategy at MUFG Securities Americas. “So the taper will affect periphery assets, beginning with cryptocurrencies and including certain stocks and high-yield debt, more than Treasuries. These securities will have to stand on their own.”
Photo: Bloomberg
