The Fed’s posture is clear: inflation needs fighting. According to markets, that will be possible only through an aggressive interest rate hiking schedule, possibly combined with a balance sheet runoff. It means that interest rates will continue to rise, contributing to a capital loss in older bonds as prices fall below par. At the same time, we’ll see the issuance of new bonds with bigger coupons in the primary market. The faster that happens, the bigger the tantrum.
High inflation makes a key difference compared to the macroeconomic backdrop during the 2013 taper tantrum. Inflation is a threat to the bond market as it erodes the present value of fixed coupon and redemption payments. Therefore, the central bank needs to hike rates to avoid an inflation tantrum. However, suppose the central bank does too little to fight inflation. In that case, bonds will lack protection against it, and markets will need to raise their future rate hike bets, creating the conditions for a selloff. Yet, if the Fed is too aggressive in tightening the economy, it might result in a taper tantrum anyway. Thus, the Federal Reserve is walking a fine line, and a tantrum is nearly inevitable as monetary policy can be too much or too little aggressive at markets’ discretion.
Real yields are one of the best tools to forecast a tantrum. As the central banks prepare for a tightening cycle, nominal yields will inevitably surge, while breakeven rates will adjust lower, accelerating the rise of real yields.
One can argue that real yields remain in deeply negative territory, leaving financing conditions still highly loose. However, that was also the case in 2013, but things started to go south as real yields accelerated their rise to 0%. We could say that the 2013 taper tantrum was all due to an acceleration in real yields.