The Daily Update: Fed Tapering

It is widely expected that the Fed will announce a start to taper at their next meeting on November 3rd, expected at a rather slow pace to start. Most observers think that they will reduce their monthly purchases by $10bn US Treasuries, and $5bn of mortgage-backed bonds each month thereafter. At that pace, if they start in December this year, then the taper will be completed in July 2022. Of course, the speed of taper is flexible and largely dependent on the continued outlook for employment and inflation.

Once this process is complete then the Fed’s next questions regarding the balance sheet will be: should they continue to reinvest maturities and interest payments into the market as they currently do? The balance sheet is currently $8.5tn with an average weighted maturity of around 8.5 years and so the reinvestment policy could be key to where the yield curve settles. Of course, the Fed also must set the funds rate appropriate for the outlook. Currently, about half of the Fed members are looking for a rate hike at the end of 2022 with the remainder looking at 2023 for a first move. Again, this will be a flexible process but the inflation question, of whether it’s transitory, will be dominant particularly if the current pressures from commodities remain and bottlenecks in the supply chain prevail.

We currently agree with the mainstream taper path, expecting the funds rate to rise after the taper has concluded in late 2022 or early 2023, as the Fed will want to get the funds rate higher from the current extremely low level. However, we continue to monitor the economic data and the effect the taper will have on economic activity and prices in the economy. It should be noted that Fed tightening is usually positive for longer-dated bonds, as seen during the 2005/2006 period when short rates moved higher by about 200bps and the curve flattened with long rates coming down as the Fed's inflation fighting stance was perceived as a positive for longer dated yields.

Does history repeat itself? Taking all into consideration we think it will, spurred on by demographics and innovation and the strong possibility the Fed will again over tighten before the economy is back on its feet.