Taper Temper
[Definition] Bond Tapering - The reduction of the rate at which a central bank (i.e., The Federal Reserve) buys new assets.
[Definition] Temper - To lessen the force or effect of something.
Many investors remember the “taper tantrum” of 2013. But how many remember that the actual tapering occurred throughout 2014? How many remember what happened to rates in 2014? I bring up these questions because it helps highlight why the reaction to the Federal Reserve’s plan to reduce its current bond buying program has been so different than the “tantrum” of 2013. Even though this round of bond buying ($120 billion per month) has roughly doubled the size of the Fed’s balance sheet since the start of the pandemic, yields have not reacted to the announcement of potential tapering as they did in 2013 when then-Chairman Ben Bernanke suggested the same during a seemingly innocuous testimony to Congress. Why is it different this time around?
Federal Reserve Balance Sheet: Total Assets Since 2008
Brief History Lesson on Quantitative Easing & the 2013 Taper Tantrum
To understand bond tapering and its potential effect on financial markets, it’s important to first understand quantitative easing. In short, quantitative easing, or “QE,” is an increasingly deployed monetary policy whereby central banks purchase government bonds, or other financial assets, seeking to stimulate economic activity by expanding money supply (a.k.a. “expansionary,” “easy,” “loose,” or “dovish” monetary policy).
[For more information and history of QE as a monetary tool following the 2008 Financial Crisis, please read this piece from the Washington Post here].
2013’s tapering announcement was unexpected and caught market participants off guard.
In the runup to Ben Bernanke’s testimony in front of Congress in May 2013, the Fed had more than doubled the size of its balance sheet, from ~$1 trillion before the Financial Crisis to over $2 trillion. By this point, the Fed was on its third round of quantitative easing, dubbed “QE III.” QE III entailed buying $40 billion in mortgage-backed securities each month and was on top of the Fed’s additional expansionary policy known as “Operation Twist.” In 2011, the Fed began Operation Twist which used proceeds from maturing short-term Treasury bills and notes to buy long-term Treasury bonds. Together the two programs were adding $85 billion in long-term bonds to the Fed's balance sheet each month.
Then, on May 22, 2013, Fed Chairman Bernanke sat in front of the U.S. Congressional Joint Economic Committee and said the following:
“If we see continued improvement and we have confidence that that’s going to be sustained then we could in the next few meetings ... take a step down in our pace of [bond] purchases.”
Prior to those words, the 10-year Treasury had hit an intraday low of 1.88%. Afterwards, the 10-year yield spiked above 2%, climbing higher until it peaked above 3% in December.
10-Year Treasury Yield (May 22 – December 31 2013)
Source: FRED
It was the unexpected nature of the Fed’s announcement that initially shocked the markets. Many had felt the economy was not yet strong enough to warrant a tightening of monetary policy. On top of that, there remained significant uncertainty and disagreement about when tapering would begin and how quickly QE III would be wound down. That roiled the markets further and led yields higher and higher. That is, until the December 2013’s Federal Reserve Policy Meeting where the Fed finally took the first step toward reducing bond purchases and unwinding QE3. At that meeting, the central bank announced it would begin reducing its pace of asset purchases from $85 billion to $75 billion per month. In 2014, tapering commenced, with QE3 ultimately ending in October 2014.
While it was understandably painful to own Treasury bonds in 2013, in 2014, the 10-year reverted back from 3% to 2.17% (nearly where it was on March 22, 2013). Long-term Treasuries (as measured by TLT) returned 27.30% after having declined 13.37% in 2013. Even though the Fed was buying fewer and fewer bonds each month, owning Treasuries as an investor would have been hugely beneficial in 2014.
10-Year Treasury Yield (December 31 2013 – December 31 2014)
Source: FRED
Source: Portfolio Visualizer
Disclaimer: Past performance is no guarantee of future results, which may vary. Investing involves risk, including possible loss of principal. The value of the investments and the income derived from them may fluctuate over time.
Tempering the Tantrum
The explanation for why markets have responded differently in 2021 to tapering is that the Fed’s announcements and actions have (thus far) been largely in line with market expectations. Back in 2013, it was not clear how the Fed would execute reducing QE nor how those actions would correspond with subsequent rate increases. Remember, the Fed’s primary stimulus tool is setting short-term interest rates as low as possible or at zero to encourage more borrowing (a.k.a. Zero Interest Rate Policy, or “ZIRP”). Quantitative easing is relatively new, having only been introduced within the past 20 years; it was first implemented as a policy tool in 2001 by Japan’s Central Bank and was later adopted by western central banks in 2008. It’s possible that since investors have now lived through actual cycles of quantitative easing and tapering, they’re more comfortable with the upcoming iteration. Moreover, this Federal Reserve is clearly more dovish than the one led by Bernanke in 2013. Case in point, the Fed now has more lenient view on inflation, having replaced a hardline 2% inflation target with a more “flexible” approach that seeks “to achieve inflation that averages 2% percent over time.” This suggests the Fed could allow inflation to run above 2%, at least over the short-term, to make up for past periods that fell below the target.
The Federal Reserve has been talking about tapering its monthly bond purchases since early this year. While investors and the Fed remain on the same page, it’s important to note that unexpected actions—and reactions—are still possible. On top of that, the systemic risk tied to the Fed’s balance sheet may now be higher than it has been at any time in history. It’s odd to recall that following the Financial Crisis many viewed the Fed’s balance sheet as too large. Oh, if they could see it now! The power of hindsight may have tempered investors’ concerns, but don’t get complacent.
Best Regards,
Adam J. Packer, CFA®, CAIA®
Chief Investment Officer | SineCera Capital