No. While the Federal Reserve’s discussion of tapering asset purchases signals a shift toward tighter monetary policy, both the Fed and markets learned valuable lessons from the 2013 Taper Tantrum; the impact on bond yields should be limited. We believe yields are likely to move higher, but in a relatively orderly fashion over the next one to two years given the strong economic outlook. The markets pricing in earlier tightening is still a risk, but an inflation scare is a more likely catalyst than taper talk.
The Fed has committed to an extended period of accommodative policies to support the economic recovery and promote its dual goals of maximum employment and price stability. However, the strong growth and inflation outlooks are testing the Fed’s commitment to its easy money policies. At last week’s policy meeting, most Fed officials indicated they now expect to begin rate hikes by the end of 2023 —instead of holding them near zero into 2024 —and discussed the prospect of dialing back the pace of the Fed’s $120 billion monthly asset purchase program.
Talk about winding down asset purchases recalls the 2013 Taper Tantrum. In May 2013, indications that the Fed could soon begin to slow the pace of asset purchases caught the bond market off guard, causing bond yields to rise sharply and equities to (briefly) sell off. Between April 30 and July 5, 2013, the nominal ten-year US Treasury yield increased by more than 100 basis points (bps). US equities suffered a peak-to-trough decline of 6% but ultimately finished up 2% point-to-point. Despite the experience of 2013, we are less worried about a sharp rise in bond yields today due to talk of tapering for several reasons.
In fact, tapering is widely anticipated. Currently, both the Fed’s Survey of Primary Dealers and Survey of Market Participants suggest the Fed will likely announce this summer that tapering will start in early 2022. This should help the Fed calibrate its messaging so as not to catch markets by surprise. Additionally, the markets had no experience with tapering in 2013 and thought tapering meant rate hikes were imminent. The overnight indexed swap forward market went from pricing in no more than 25 bps of Fed rate hikes over the next two years to pricing in as many as 130 bps. In contrast, the market has only priced in an additional 20 bps of tightening over the next two years since last week’s meeting, or roughly 60 bps total, which is in line with the Fed’s expectations. Another potential reason market expectations might be better anchored today is the Fed’s new flexible average inflation target (FAIT) framework. In short, it suggests the Fed will lag growth/inflation and keep policy easier for longer than in the past. Lastly, nominal ten-year US Treasury yields have already risen substantially from their cyclical lows (roughly 100 bps), which could limit any further rise in yields.
Given these factors, we think the more likely outcome is that bond yields will resume their cyclical upswing but in a relatively orderly fashion over the next one to two years given the strong economic outlook. There is still a risk the markets pricing in earlier tightening causes yields to rise more sharply than we expect. We just don’t think talk of tapering is a likely catalyst. In our view, the bigger risk this cycle is a change in the inflation narrative, especially given uncertainty about the Fed’s reaction function under FAIT. So far, the Fed and market consensus (Cambridge Associates included) agree inflationary pressures are likely transitory, but a stronger and more persistent rise in inflation could prompt markets to price in an earlier tightening cycle, even if the Fed continues to look through the rise in inflation.
Equities more broadly should be able to digest an orderly rise in yields, but they are vulnerable to a sharp rise in yields because of elevated valuations. In such a scenario, cyclicals and value stocks should hold up better than the broad market. These segments outperformed during the 2013 Taper Tantrum and they should be better positioned if inflation increases more than expected. Within core fixed income, we continue to favor assets that are likely to outperform in both a rising and stable interest rate environment, such as Chinese sovereign bonds.
TJ Scavone, Investment Director on Cambridge Associates’ Global Investment Research Team