By Simon Tryzna, CFA, Chief Investment Officer
One of the hottest words in investment commentary, my own included, has been "tapering." Last week, at their annual Federal Reserve meeting at Jackson Hole, all eyes and ears were on Federal Reserve Chairman Jerome Powell's speech where he outlined the current stance of the Fed, what tapering could look like, and when it could start. As we head into the fall months and then into 2022, commentary on tapering will continue to grow. With that backdrop in mind, I wanted to put together a quick primer on tapering, some other key words associated with it, and how it could unfold in the U.S. based off of Chairman Powell's speech.
What is Tapering?
In the capital markets, "tapering" refers to the winding down of certain central bank activities. It was first coined in May 2013 by Fed Chairman Ben Bernanke in a testimony before Congress, when he alluded that the Fed may "taper" or reduce the size of its bond-buying program known as Quantitative Easing (QE). QE is a process by which central banks purchase bonds and other longer-term securities from the open market in order to increase the money supply and encourage lending and investment. By taking loans off of banks' balance sheets and putting them on their own, more "cash" is available to be lent and utilized by the banks, which, in theory, should help stimulate economic growth.
Since March 18th, 2020, the Fed has been purchasing $120 billion worth of bonds ($80b of Treasury Securities and $40b of mortgage-back debt) per month as one of their responses to the Covid-19 pandemic. They do that because banks are hesitant to give out new loans in an economic downturn in fear of the borrower defaulting on them. In addition, banks are required (by the Fed) to maintain at least 10% of their deposits in cash (this was waived during the Covid-19 pandemic). By purchasing bonds in the market, the Fed effectively reduces the default risks that banks have and gives the banks the peace of mind needed to continue to provide loans. By constantly being a buyer of Treasury securities, the Fed keeps bond interest rates low, which get passed on to the banks and the borrower. As a byproduct of this, corporate and mortgage interest rates were at recent record lows in 2020, which allowed many corporations to refinance and restructure their debt, and many homeowners to refinance their existing home or purchase a new one. The less interest corporations and individuals have to pay, the more cash they have available to spend, thus stimulating the economy.
When talking about the Fed tapering, it simply means the winding down of their monthly bond purchases. The biggest question is always around time and by how much. A "good" taper by the Fed, would begin in December and be at about $5 - $10 billion per month. In other words, in December, the Fed would only purchase $115 billion, in January $110b, and so on. This scenario would mean that we'll continue to have QE through 2022.
At the moment, the markets are pricing in a tapering rate of $15 billion / month. This outcome isn't necessarily bad, but with COVID uncertainty and rising economic growth concerns, the market would be more sensitive to the Fed following this procedure.
An "ugly" taper would be $30 billion per month (or, really, anything higher than $15 billion). This would be a shock to markets and substantially increase stagflation concerns because the Fed would be aggressively tapering QE. The uptick in COVID cases would clearly signal that the Fed is nervous about inflation regardless of the loss growth. Some Fed officials do want to go this high (or at very worst, begin tapering sooner). However, this week's economic data (mainly the August Jobs Added report) should keep these officials in the minority.
How can the Fed be Hawkish or Dovish?
The hawk and dove stance is referred to the monetary policy beliefs of central bank members. A monetary hawk (or someone who takes a hawkish position) favors keeping inflation low as the top priority in monetary policy. A monetary dove prefers the policy to favor other issues, like economic growth or low unemployment.
A dovish stance by the Fed would favor economic growth and hopes of improving the unemployment rate over keeping low inflation and would be considered "expansionary monetary policy." The current QE program is a very dovish approach – the Fed has been very loose with policy, very accommodating to the markets, and providing incredible levels of liquidity with its bond-buying program. Because of those factors, inflationary fears have become a real concern in the capital markets.
A hawkish stance by the Fed would lead to a "restrictive monetary policy." Hawks oppose QE, as they see it as a distortion of asset markets (something many market participants commented on during the market recovery in 2020). Hawks usually project a higher risk of inflation and see it as a bigger worry than others. Any comments that are perceived to be hawkish from the Fed would prioritize inflation and look to reduce QE. A bond tapering program of $30 billion a month would be very much a hawkish stance.
Thoughts on Chairman Powell's speech
On Friday, August 27th, Fed Chair Powell gave a (virtual) speech from the annual Jackson Hole Economic Symposium. In it, he delivered comments perceived as dovish, in which he confirmed that tapering would begin this year, likely in December. While he did mention the Delta variant a few times, he largely dismissed it as a short-term threat. More importantly, Powell reaffirmed his belief that inflation is temporary. If he views it as temporary, it means the Fed is likely to remain dovish and not be concerned with what could be perceived as high inflationary numbers. This means that QE is likely to continue until the objectives of the Federal Reserve (low unemployment, strong economic growth) are met.
From talking with some of our fixed-income teams, it appears that there is no true market consensus on what the Fed will do. However, all of them cite economic growth (or lack thereof) as the real driver of upcoming Fed decisions. They warn that inflation could get to a point where the Fed will need to start doing something, even if the other economic numbers aren't where they want them to be. This scenario would lead to a stagflationary environment.
All in all, things are still in alignment for a "risk-on" environment. However, as market participants collectively return back to work after Labor Day Weekend, every piece of economic commentary and every comment from any Fed official will be scrutinized even more.