The Fed learned its lesson about transparency
Quantitative easing fulfilled its goals of stability & liquidity
US yields remain attractive on a relative basis
The lights are on and the stadiums are packed which means football is finally back! While the college season has already started, our defending champions from Tampa Bay kicked off the start of the professional league in last night’s thrilling come from behind victory. Whether it be the crowd noise, tailgating, or the excitement of live sports, signs of normality continue to grow as inoculations increase. In addition to football, this fall will be eventful for our team of monetary policymakers at the Federal Reserve. Quarterbacked by Chairman Powell, the Fed will draft its route to easing its accommodative stance now that the economic recovery has put some points on the scoreboard. While there are still some yards to cover before maximum employment is achieved, we expect the opening play will be announcing tapering at the November meeting and starting the reduction of purchases in December.
Bottom Line—The Fed Is Full Of Seasoned Veterans | Some investors are fearful of the Fed reigning in its accommodative policies, but it is important to note that this is not the first time the Fed has ‘tapered’ its bond purchases or the first time the financial markets have had to react. Below are reasons why these fears toward Fed tapering may be misplaced:
The Fed Has Shared Its Playbook | Less than a decade ago, then Fed Chairman Bernanke suggested that the level of bond purchases implemented to support the financial markets after the Great Financial Crisis would be reduced, which led to a ‘taper tantrum’ as both interest rates and volatility spiked. History is unlikely to repeat itself, as the Fed learned the lesson of being as transparent as possible in its intentions. Case in point, Chairman Powell first commented on the economic parameters that would need to be satisfied for the tapering discussion to even begin last December, when our nation was grappling with its worst surge of cases yet. Over the last several months, he has chosen his words wisely, gradually shifting from “talking about talking about” bond tapering to confirming that the consensus view is that the economic progress made now justifies doing so soon. As such, Google trends suggest that the topic of ‘tapering’ has reached its pinnacle in terms of searches in recent weeks as the prospects for the Fed reducing ultra-accommodative policy is now truly ramping up.
Spreads Snapped Back To Pre-COVID Levels | As many of the Fed officials have implied, the goals of quantitative easing are to increase confidence, narrow credit spreads, reduce volatility, and raise asset prices. Since the onset of the pandemic and the implementation of such actions, these four goals have all been achieved. First, investor, consumer, and business confidence have all increased, reflected in consistently strong personal consumption and business spending plans. Second, credit and high-yield spreads are near multi-year lows. Third, market volatility has subsided, with the S&P 500 experiencing less than half the number of +/- 1% swings it had experienced by this time last year. And lastly, asset prices have surged, leading net worth levels to reach record highs. Given the success of quantitative easing so far and the diminishing impact of further purchases, it is prudent for the Fed to sideline this tool for any future economic crisis.
Moving The Goal Posts For Growth Expectations | The Fed has drawn a clear line differentiating between tapering and tightening (e.g., raising rates). The goals of quantitative easing outlined above were designed to maintain the stability and liquidity of the market, reflected in record equity prices and record low spreads, whereas raising rates is a tool used to slow the economy or inflation. As of now, the Fed has no intention of restraining economic activity, especially as the labor market needs to create more than five million jobs to make up for the jobs lost during the pandemic. As such, our expectation is that interest rate hikes will not be implemented in tandem with tapering, and will instead be delayed until 2023.
US Never Joined The Negative Interest Rate Huddle | There has been a big decoupling of yields between the US and overseas markets since negative interest rates were introduced in 2014. Even in the midst of the pandemic, the Fed was clear that they were not willing to go down that path, which has kept US bonds attractive from a global perspective. With still-strong foreign demand intact seeking the higher US rates, longer-term interest rates are unlikely to surge above the 2% level, keeping borrowing costs low and equity valuations relatively attractive.
Market Will Be Able To Tackle The Net Supply | The Fed was a major buyer of bonds as the US government issued a record amount of debt to fund the series of fiscal stimulus packages. In fact, the Fed has purchased over $2.5 trillion since the pandemic! With the funding needs of the US government expected to decline nearly 30% in 2022, there will be less overall issuance next year. Even though the Fed’s 2022 purchases will dwindle, the net supply of bonds that the rest of the market (e.g., excluding the Fed) needs to absorb will remain relatively unchanged.
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