Tapering: what is it and why should you care

Tapering: what is it and why should you care

Bonds
Althea Spinozzi

Senior Fixed Income Strategist

Summary:  In this article, we want to explain why tapering matters for your portfolio. In an accessible Q&A format, we outline what happened with tapering in the past what it could mean for markets today.


What does tapering mean?

When Federal Reserve's members talk about tapering, they refer to the gradual slow down of the pace of its large-scale asset purchases. Thus, it's talking about reducing the Fed's balance sheet's expansion pace,  also known as Quantitative Easing (QE).

The subsequent step to tapering is considering whether to reinvest maturing securities or to reduce its balance sheet. The central bank can decide whether to reduce its balance sheet gradually by letting maturing securities “runoff” without reinvesting or to sell assets actively.

What is Quantitative Easing (QE)?

QE refers to central banks' asset purchase programs created to stimulate the economy. It is a form of monetary policy used to increase the domestic supply of money and spur economic activity.

Central banks turn to quantitative easing when the short-term interest rate plunge 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 borrowing and mortgages cheaper. By buying government debt and Mortgage-Backed Securities (MBS), the central bank reduces these instruments’ supply in the broader market. Investors who decide to hold these instruments need to raise their bids, pushing yields down.

In the wake of the Covid pandemic, the Federal Reserve cut short-term interest rates to zero in March 2020. Starting from July 2021, the Federal Reserve has been buying $80 billion of US Treasuries and $40 billion MBS to stimulate the economy to ensure a fast economic recovery.

Is QE different today compared to other times in history?

Currently, the Fed is purchasing Treasuries across a broad range of maturities to mitigate the shock provoked by the COVID-19 last year. However, QE before was involving long-term maturities. Therefore tapering could impact the yield curve differently.

Why is the Federal Reserve looking to reduce the pace of asset purchases?

The simple answer to this question is: because the economy doesn't need stimulus any longer. The US economy is estimated to grow an eye-popping 6% this year and 4% next year. At the same time, inflationary pressures and excessive risk-taking in markets accelerated significantly, making the termination of QE a natural outcome. However, Jerome Powell has recently highlighted that "substantial further progress" is needed to begin tapering. These remarks can be linked to the central bank's full employment target. The Fed is looking at the pre-COVID unemployment rate, roughly 3.5% and set it as a target. Although the central bank commits to full unemployment for a noble cause, the risk here is that the economy overheats, and its QE program continues to stimulate inflation.

What is a “taper tantrum”?

"Taper tantrum" refers to a particular episode that happened in 2013.

Following three rounds of QE to stimulate the economy after the Global Financial Crisis (GFC), Fed's Chair Ben Bernanke prepared the market for a decrease of purchases in May 2013. The following month, he revealed a tapering plan. Yields rose from 2.2% to 3% during summer despite Bernanke and other Fed members emphasising that any reduction would be gradual and not be related to any interest rate hikes. The sudden increase in US treasury yields caused capital outflows and currency depreciation in emerging markets like Brazil, India, Turkey and South Africa.

Regardless, the central banks began to taper in December that year, reducing the pace of asset purchases by $10 billion per month, starting from $85 billion. The asset purchase program ended in October 2014. The Federal Reserve, led by Janet Yellen, began shrinking its balance sheet a year later.

Can tapering in 2021 provoke another “taper tantrum”?

Compared to 2013, Jerome Powell has tried to decouple tapering talks with interest rate hikes this year. Indeed, he stated clearly said that tapering will precede any rate hike consideration.

Additionally, tapering doesn't mean that the Fed's balance sheet is going to shrink anytime soon. It will continue to grow (although at a slower pace) until tapering ends, thus providing stimulus to the economy. Under this point of view, tapering shouldn't be a big game-changer for the bond market.

Yet, tapering gives a signal surrounding the central bank's future policy intentions, impacting long-term interest rates. Expectations of less accommodative policies can spur a selloff in the long part of the yield curve before the Federal Reserve even begins to contemplate shrinking its balance sheet.

It's also important to highlight that tapering may be introduced in the last quarter of the year, where we might see the reflation trade come back to life as growth and inflation continue to be supported.

In conclusion, we might not run into a taper tantrum, such as it happened in 2013. Still, the rise in yield may be explained by economic fundamentals and accelerated by the Fed's monetary policy intentions.

Why reducing the Fed’s balance’s sheet size can be more problematic than tapering?

Because it increases the asset supply in markets while demand remains unchanged, it could provoke a rise in yields, thus tightening economic conditions.

Since the Global Financial crisis, the Federal Reserve decided to slowly wind down its balance sheet only once from October 2017 until September 2019. However, it didn’t end up well.

In mid-September 2019, money market rates spiked in a sign of distress due to the corporate tax date and increased US Treasury supply. The Federal Reserve had to announce an overnight repo operation to add reserves to the system. A month later, the Fed had to re-introduce QE purchasing Treasury bills at a pace of $60 billion per month. It continued to do so until the second quarter of 2020, when Covid happened. Then, the Fed had to step up its accommodative measures.
Source: Bloomberg and Saxo Group.
Disclaimer

The Saxo Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website is not intended to and does not change or expand on this. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-sg/legal/disclaimer/saxo-disclaimer)

None of the information contained here constitutes an offer to purchase or sell a financial instrument, or to make any investments. Saxo Markets does not take into account your personal investment objectives or financial situation and makes no representation and assumes no liability as to the accuracy or completeness of the information nor for any loss arising from any investment made in reliance of this presentation. Any opinions made are subject to change and may be personal to the author. These may not necessarily reflect the opinion of Saxo Capital Markets or its affiliates.

Saxo Markets
Most of our staff in Singapore are working from home to help limit the spread of the coronavirus. We remain at your service on the details below. Thank you for your understanding.

Contact Saxo

Select region

Singapore
Singapore

Saxo Capital Markets Pte Ltd ('Saxo Markets') is a company authorised and regulated by the Monetary Authority of Singapore (MAS) [Co. Reg. No.: 200601141M ] and is a wholly owned subsidiary of Saxo Bank A/S, headquartered in Denmark. Please refer to our General Business Terms & Risk Warning to consider whether acquiring or continuing to hold financial products is suitable for you, prior to opening an account and investing in a financial product.

Trading in financial instruments carries various risks, and is not suitable for all investors. Please seek expert advice, and always ensure that you fully understand these risks before trading. Trading in leveraged products such as Margin FX products may result in your losses exceeding your initial deposits. Saxo Markets does not provide financial advice, any information available on this website is ‘general’ in nature and for informational purposes only. Saxo Markets does not take into account an individual’s needs, objectives or financial situation.

The Saxo trading platform has received numerous awards and recognition. For details of these awards and information on awards visit www.home.saxo/en-sg/about-us/awards.

The information or the products and services referred to on this website may be accessed worldwide, however is only intended for distribution to and use by recipients located in countries where such use does not constitute a violation of applicable legislation or regulations. Products and Services offered on this website are not intended for residents of the United States, Malaysia and Japan. Please click here to view our full disclaimer.

This advertisement has not been reviewed by the Monetary Authority of Singapore.