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Are we due for a taper tantrum?

Recent market commentary has focused on the prospect of a possible rerun of 2013’s spike in bond yields should the US Fed begin to rein in its asset buying programme. Such fears could be overblown, argues Sebastian Vismara, economist with BNY Mellon’s Global Economics and Investment Analysis team.

With US GDP climbing above its pre-pandemic level in Q2 2021 and inflation remaining high and above its 2% target, the Federal Reserve has started discussing how and when to taper its asset purchases and is expected to communicate its decision over the coming months.

The last time a similar watershed was reached – in May 2013 when Fed chair Ben Bernanke suggested to Congress that tapering was on the cards – the response was immediate: a spike in sovereign bond yields and a sharp rise in volatility across both the wider bond and equity markets.

Today, investors face a similar question: could a reduction in the Fed’s bond buying programme spark a sell-off and subsequent spike in yields?

For Sebastian Vismara, economist with BNY Mellon’s Global Economics and Investment Analysis (GEIA) team, the question is an important one but not something for immediate concern. The team at BNY Mellon acknowledge this risk, but argue that a moderate, overall well-behaved, rise in yields is the most likely outcome.

The road to recovery: possible future scenarios

Here, Vismara refers to the most recent edition of Vantage Point, the GEIA team’s quarterly macro-economic overview, which considers possible outcomes for the post-pandemic global economic recovery.

In what the GEIA team calls its ‘Good Recovery’ scenario - to which it assigns a 45% probability - the Federal Reserve starts tapering in early 2022, with quantitative easing (QE) finishing by the close of the year or the start of 2023, and the first rate rise taking place at around the same time.

In this view of the world, the timing and pace of a reduction in QE purchases is broadly in line with market expectations, so there is no taper ‘surprise’. In addition, having learned from the 2013 taper tantrum communication mistake, the central bank is clear in communicating that policy will remain loose for some time to come. As such, bond yields rise moderately following the announcement.

A second scenario – the ‘Tight Money’ scenario, to which the team assigns a 30% probability – sees the Fed interpreting the rise in inflationary pressures as persistent, with QE tapering and additional monetary policy tightening announced as soon as at the end of 2021 and rate rises shortly after, which surprises the market. In this scenario, real interest rates would rise to bring inflation down, overshooting to the upside. Risky assets would fall and financial conditions tighten.

In the GEIA team’s third scenario – its ‘Overheating’ scenario, to which it assigns a 15% probability – the growth trajectory and build up in inflation are similar to the ‘Tight Money’ scenario, but, the Fed maintains a loose policy stance for longer. In this scenario, the rise in yields is strong but steady, with less of an overshoot higher in interest rates in the near term, as the market gradually prices in a future tightening in monetary policy.

The final scenario outlined by the GEIA team refers to a ‘Bad Recovery’ with a 10% probability. Here, new variants of Covid-19 disrupt the re-opening of economies, with a resulting decline in growth, inflation and yields.

Yields and the balance sheet

The two fan charts below summarise the outlook for the Fed balance sheet and US 10-year Treasury yields, according to Vismara.

In the first fan chart we can see an expected slowing in asset purchases and possibly even a reversal before too long. Our mean path for the overall size of the balance sheet is a gentle downward slope from the beginning of next year, with a balance of risks pointing to a potential faster unwinding of asset purchases. For instance, we see close to a 1-in-10 chance that the additional QE put in place to combat the economic consequences of the pandemic will be unwound by the end of our forecast horizon in 2023.

On the fan chart for 10-year US Treasury yields, Vismara notes that the sharp upward spike in yields later this year reflecting the possibility of a second ‘taper tantrum’ in the ‘Tight Money’ scenario. In the ‘Good Recovery’ scenario, yields climb steadily higher over the next year or two, before settling at around 2.5%. Overall, risks around the path for yields are skewed to the upside in the near term but are broadly balanced further out.

Footnote: The solid line shows the good recovery upside scenario mode and the dashed line is the mean or probability-weighted average forecast across all four scenarios. The darker bands towards the centre of the fan chart show the more likely outcomes, while the lighter bands show progressively less likely outcomes covering 90% of the forecast distribution. The width of the fan chart shows the level of uncertainty and when the bands below the central forecast are wider than those above shows the balance of risks lies to the downside. Forecasts begin in Q2 2021 and were calculated as of June 2021. Source: BNY Mellon GEIA and Fathom Consulting.

About the author

Sebastian Vismara, Financial Economist, BNY Mellon Investment Management

Sebastian Vismara is a Financial Economist in the Global Investment Strategy team at BNY Mellon Investment Management. His responsibilities include conducting analysis on the global economy, financial markets and investment implications.

Prior to this role, Sebastian spent 5 years at the Bank of England working on global macroeconomic analysis and financial market research. In his last role he provided macro financial research support for Governor Carney's international meeting engagements.

A native of Italy, Sebastian has a two-year Masters in Management with a concentration in Finance from the London School of Economics and an undergraduate degree in International Relations with a concentration in Economics from the University of Florence in Italy.

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