Investors are concerned about the prospect of a “Fed Taper ”, but history shows that this will likely be good news for the bond market. Currently, that does not appear to be the case, with rates rising after the announcement. As reported by CNBC:
“While the Fed has already made a political withdrawal, it has never pulleD back from such a dramatically accommodating position. Over the past eighteen months, he has bought at least $ 120 billion in bonds every month. Such a provisioned unprecedented support for financial markets that he is going now backwards.
“Bond purchases added more than $ 4 trillion to the Fed’s balance sheet, which now stands at $ 8.5 trillion. Roughly, including $ 7 trillion in assets purchased under the Fed’s quantitative easing programs. Purchases helped keep interest rates low. This has provided support to markets that have malfunctioned over the course of the pandemic and fed a powerful race for the stock market.
Previously, when the Fed started cutting its bond buying programs, the market collapsed as the ” at risk ” reverse trade.
As was the case before, Wall Street analysts quickly assumed this time would be different despite previous debacles.
“When Federal Reserve officials spoke of the withdrawal of accommodative policies in 2013, anxious investors made the markets dizzy.
The opposite is happening now: The Fed has signaled that it has started discussions on reducing bond buying programs. Investors, however, remain placid. The markets, in short, are picking up pace. – WSJ
This is the case for the moment. Now let’s see how the potential impact of the Fed’s tapering announcement may be good news for the bond market.
Global liquidity slows
While Wall Street is eternally bullish, there are two problems with the idea that the Fed can cut liquidity without consequence.
For starters, it’s not just the Fed that is cutting liquidity. Global liquidity, from central banks and governments, has started to reverse by 2022.
The hope, of course, is that the economy is now strong enough to “Stand alone” without continued support. But, as discussed in the economic growth is already well below expectations.
“Over the next few quarters, year-to-year comparisons will become much more difficult. Q2-2021 will probably mark the peak of the economic recovery.“
During each previous QE cycle, as soon as the cash flow slowed or stopped, the unwanted results were close.
Awaken the Bond Bull
The recent “pop” rates, when the Fed announced it would cut its bond purchases, was not surprising. Such is the expectation if one of the main sources of bond buying is removed.
“In theory, tapering should lead to higher interest rates. By reducing its bond purchases, the Fed increases the supply that must be absorbed by the market. Such signals indicate that the policy is becoming less accommodating. – Schwab
However, over the past decade, a shift in Fed policy has repeatedly offered bond buying opportunities. In the past, rates rose during quantitative easing programs as money flowed out of the “Security of obligations” back in action (risk-on.).
When these programs ended, rates fell as investors reversed their risk preferences.
As the Fed begins to shrink, investor risk preferences will change as liquidity decreases. This will be the case for three reasons.
- All interest rates are relative. With trillions of global debt showing negative interest rates, the assumption that US rates are about to skyrocket is probably wrong. Higher yields on US debt attract capital flows from negative yielding countries, lowering US rates
- The upcoming budget deficit balloon. Given the lack of control over fiscal policy and continued pledges of largesse, the budget deficit will exceed $ 4 trillion in the coming years. This will require more government bond issuance to fund future spending.
- Central banks will continue to be bond buyers to maintain market stability, but will become more aggressive buyers with each recession.
With the current administration and the Treasury pushing for an increase in public spending, the budget deficit is already on the rise, with economic growth well below expectations. This will promote more, not less, demand for bonds in the future and that is potentially good news for the bond market.
Bonds could outperform
Here is the main point. As market experts continue to push a narrative that “Actions are the only game in town”, it will probably be bad advice. But this is the nature of a media analysis with a lack of experience or historical perspective.
In many ways, the absolute risk of high equity exposure in the portfolios is outweighed by the potential for additional reward. The realisation of “risk,” when it does, will cause markets to unwind quickly, pushing volatility up and bond yields down. This is why we continue to buy bonds on market rallies to hedge against future market dislocation.
In other words, we get paid to hedge risk, reduce portfolio volatility, and protect capital. The obligations are not dead. In fact, they will probably be your best investment in the not too distant future.
In the short term, the market could surely rise further, especially if the Fed continues to reinvest the proceeds from its balance sheet. This is a point I will not discuss as investors are historically inclined to seek returns until the very end. But in the medium and long term, the consequences are entirely negative.