However,the taper is in the price this time round. The chart below left shows that rates volatility is already off its cycle lows (we noted back in December that it was too low for the likey taper risks this year). And we reckon 10y yields around current levels are fair for market conditions: unlike in 2013, when the FOMC dot-plot forecast implied terminal rates at 4%, the current long-run dot is 2.5%; this means there is little headroom for a tantrum from a starting point of 1.6% to a terminal rate of 2.5%. Furthermore, as the chart below right shows, primary dealers expect the Fed to cut its asset purchase pace to zero by the end of 2022. Both risk pricing and survey expectations suggest the taper is currently in the price.
Fed Chair Jay Powell suggested last week that the Fed would follow the 2013/14playbookfor this round of tapering. We presuming this refers to the pace of reduction rather than inducing a tantrum; once tapering started in Dec 2013, the central bank announced a$10bn/m reduction in asset purchases at each FOMC meeting–every six weeks–from January to September(and a $15bn reduction to zero at the October meeting). The pace presumed by the NY Fed Primary Dealer survey (see right-hand chart on the previous page) is, in fact, slightly more rapid than this, assuming a reduction in pace of $10bn per month ($30bn each quarter). Besides, we reckon the lesson to learn from the2013/14 playbook is one of caution: if themarket feeds back that the Fed is removing accommodation too quickly, the central bank will slow the taper pace.
What pace of reduction can the economy absorb? It’s not just how fast the Fed goes that matters. Back in December we laid out why rising coupon supply was a risk to Treasury yields, and this supply outlook is also key:net issuance to the private sector matters, not just what one or the other side of the government’s balance sheet is doing. During the 2014 taper the budget deficit was falling, too (i.e.,Treasury issued fewer bonds in 2014 than in 2013) so although Fed purchases fell by $300bn from 2013 to 2014, net supply to the private sector rose by just half that. During the first year of QT, Treasury issuance doubled to nearly $600bn to fund a larger budget deficit (thanks to Trump tax cuts) and Fed policy added another $200bn to net supply. The economy was able to absorb the 2014 taper but ultimately struggled in 2018. The net issuance change in this taper could be very small. The top-left chart uses the CBO forecast of $1.5trnbond issuance in FY 2021 and $1trn inFY2022, and the NY Fed survey as an approximate taper pace. In the current year the private sector will finance $540bn of net issuance. Next year, once accounting for a smaller budget deficit and slower pace of Fed purchases, the private sector will finance $595bnof net issuance. This change (+$55bn) is smaller than in 2014 (+$150bn) and 2017 (+$450bn).The economy will comfortably be able to absorb this pace of reduction. Perhaps more important, the taper is enabled by the fiscal policy outlook: if issuance were to rise sharply over the next few year and the private sector were to need to fund more of the deficit, the Fedmightreconsider its pace of removing accommodation. Implicitly or explicitly, fiscal policy is dominant.
As a price-insensitive buyer is removed, markets will start to trade closer to fundamentals. Last year we showed that (during non-crisis periods) the underlying effect of balance-sheet expansion on stock prices was to reduce volatility and cut the left tail of the distribution of returns (top-right chart). So, while the private sector should be able to comfortably absorb the taper, the lower volume of price-insensitive support means prices become more sensitive to underlying fundamentals and volatility rises.
This taper will be important, albeit in a different way.Back in 2014, the dollar staged a strong rally as the ECB is cut rates and prepared for QE; the oil price fell by nearly 50% as shale oil and tar sands led to a Saudi-driven price war. Was the taper also a trigger? Tighter Fed policy always creates unexpected consequences. But this time around the macro backdrop is different: the global economy is recovering from crisis and the Fed is reducing accommodation because the economy is robust enough to absorb it.
But that does not mean there are no risks on the horizon. Record-high equity valuations are an unavoidable risk: high valuation means longer asset duration or, to put it another way, a longer payback time for your investment and, as Andrea Cicione shows in today’s Daily Note, the relationship between equity multiples and balance-sheet expansion means one must respect the risk to valuations from the taper. In contrast with2014, when PE ratios were still recovering from the crisis (only reaching the pre-crisis17x level by the end of the year), the direction of risk to valuations at their current level is lower, not higher.
Where is the risk in this taper? The announcement is in the price; the combination of lower prospective Treasury issuance at the same time as fewer central bank asset purchases means the event risk should pass uneventfully.But the absence of a significant price-insensitive purchaser changes the distribution of equity returns; and once the taper is announced, the clock starts ticking for the first rate hike. While that won’t happen until the end of 2022, which is a long way away, it adds another reason to approach the taper period with an abundance of caution. We see taper risk as back-rather than front-loaded: we want to own hedges for after, not around the Fed’s taper announcement.
Cognizant that the first half of the 2014 taper was a low-vol environment we do not pull the trigger on a new hedge this week. We are watching equity vol, but right now the VIX curve is steeply upward-sloping, offering no value for a long-term view. In FX vol, forward curves are flat (conversely, offering no taper risk premium) but levels are relatively high, so we monitor AUD/USD and AUD/JPY1y volatility for lower entry levels before adding any new portfolio hedges. We are also well hedged before then with an HYG put and long-vol exposure through our USD/TWD call and payer swaption position. This time there will be no pre-taper tantrum. But there could be a tantrum during the taper.