What happens when the Fed stops BRRRRRRR…

TS Lombard with the note:

  • The next Fed risk is the taper, likely to be announced in the summer.This is priced in–and the effect on net issuance is smaller than in 2014 or 2017
  • But no matter how well telegraphed, this taper will still change the market as a price-insensitive buyer leaves and the clock for rate hikes starts ticking
  • Time to reduce risk? Not yet, but we monitor long-term vols to enter hedges: the taper risk is not the announcement but (later) the process itself

Here we go again. The benchmark US 10y yield is around 1.6% and the Federal Reserve is close to a major change in its asset purchase programme. We expect the Fedto announce the taper in the summer. When we were here in 2013(before the first round of tapering)and 2016(before quantitative tightening, QT), bond markets had tantrums, which were ultimately the result of investor complacency: in both cases, rates volatility was at cycle lows and in 2013 the 10yyield was lower than fundamental market conditions required because eof complacency around presumed continued central bank support.

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.

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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.

David Llewellyn-Smith