The Big Idea

This is not a taper tantrum

| February 26, 2021

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Treasury yields have backed up sharply in February with the rise picking up speed in recent sessions. But this is not a second taper tantrum. In 2013, market participants reacted to a perceived change in the Fed’s reaction function amid a steady or, at best, a slowly improving economic picture. The current episode reflects a reassessment of the economic outlook not sparked by the Fed. If anything, the Fed in this case seems more pessimistic than market participants about the economic and monetary policy outlook. Fed officials are pushing in the opposite direction, trying to convince the market they will remain easy for a long while yet.

QE infinity

To set the stage for the 2013 taper tantrum, it is necessary to begin years before. After the Great Financial Crisis, the economic recovery had proven sluggish. The FOMC had done rounds of QE in 2009 and again from 2010 through 2011. In each case, the Fed had announced an amount and a timeframe for the purchases. The Fed set purchases of Treasuries in March 2009 at $300 billion over six months. The Fed then set a second round of QE in November 2010 for $600 billion in Treasuries through the middle of 2011. In each case, the Fed carried out the asset purchases as announced and ended just as scheduled in the initial plans.

Later in 2011, the Fed embarked on what came to be known as Operation Twist, committing to buy $400 billion in longer-term Treasuries while selling an equal amount of short-term Treasuries. Again, there was a fixed quantity and an explicit end date set as June 2012 and later extended to the end of 2012.

Many on the FOMC were frustrated with how those rounds of QE played out. Fixing beforehand the quantity and timeframe for purchases created an inflexible tool that did not allow for adjustments as the economy evolved. When the Fed began to contemplate yet another round of QE in 2012, it sought to create a new framework for purchases.

In September 2012, the FOMC unveiled this new approach. The committee announced it would buy $40 billion a month of agency MBS until it saw substantial improvement in the labor market outlook. Once Operation Twist ended in December 2012, the FOMC announced that month that it would also buy $45 billion a month of Treasury securities, with the same conditions.

The FOMC did not do an adequate job of explaining to financial market participants why it had moved to this new framework. What most investors saw was that the FOMC had moved to an open-ended QE program, with no prospect of completion in sight. By early 2013, this third round of QE had come to be known by many investors as “QE infinity.”

The FOMC spent most of 2013 debating what level of unemployment was consistent with “substantial improvement,” and in the absence of a clear consensus, the Committee was unable to offer unified and coherent guidance to financial markets. Thus, investors came to be lulled into a sense that asset purchases would continue for as far as the eye could see.

Taper tantrum

While financial market participants assumed that the Fed would have their backs with massive securities purchases forever, the reality was that the labor market situation was slowly but steadily firming. The unemployment rate sank from 8% in January 2013 to around 7.5% in the spring. Moreover, the support for a third round of QE had been shaky to start with, with several of the more hawkish Fed officials growing increasingly antsy with the seemingly endless balance sheet expansion. A divided FOMC started in the spring of 2013 to debate what economic conditions might justify a taper.

Chairman Bernanke first raised the possibility of tapering Fed purchases at his May 22 Congressional testimony. Market participants were clearly unprepared for the prospect. After bottoming out around 1.60%, 10-year yields shot up to 3% over a roughly four months (Exhibit 1).

Exhibit 1: The 10-Year Treasury yield in the year of the taper tantrum

Source: Bloomberg, Amherst Pierpont Securities

In thinking through why the taper tantrum happened, it seems clear that it was mostly a change in financial market participants’ perception of the Fed’s reaction function. The markets had come to believe, rightly or wrongly, that QE would go on for months and months, if not years, based on the disappointing pace of economic recovery. The committee had done a poor job of explaining why it had switched to an open-ended QE program in the first place, and markets were caught by surprise when Chairman Bernanke brought up the possibility of tapering.

There was another nuance to the taper tantrum. The FOMC had also not been able to convince market participants that the reaction function for asset purchases and for rate policy were different. Investors assumed that if the Fed was prepared to taper, then it was also getting closer to lifting off of the zero bound.

In any case, the important point is that the taper tantrum was a case of the Fed doing a poor job of communicating the thinking behind its decisions. Chairman Bernanke’s taper talk led market participants to recognize they had misread the Fed’s intentions with regard to monetary policy and to adjust expectations accordingly—in fact, to over-adjust—even as the economic outlook had not changed very much.

Not a 2021 taper tantrum

In that sense, the backup in Treasury yields in early 2021 might seem on its surface like a second taper tantrum, but, in fact, it is very different. The backup in 10-year yields gathered steam within the last week and totaled more than 60 basis points for the year through February 25 (Exhibit 2).

Exhibit 2: The 10-Year Treasury yield in 2021

Source: Bloomberg.

The details of the current episode are very different from 2013. Fed officials have been scared to death of creating a second taper tantrum and have gone well out of their way to avoid any hawkish surprises in their communications. In fact, when several Fed officials in January began to speculate on the possible timing of a taper, it appears that Chairman Powell shut down that talk at the January FOMC meeting. Since that meeting, Fed officials have only repeated that they would need to see “substantial further progress,” which would likely take some time, and that it was too soon to guess when that would be.

Financial market participants consequently have no particular reason to change their presumed Fed reaction function. Instead, the 2021 Treasury market sell-off has been more a function of rising optimism with regard to the economic outlook. As Covid cases and hospitalizations have receded from an early January peak and vaccinations are steadily progressing, the prospect of a broad economic reopening is becoming more likely.

In fact, while Fed officials have been careful not to say anything that would appear to represent displeasure with the backup in Treasury yields, they have also gone out of their way to reinforce their position that asset purchases are unlikely to be tapered for quite some time and that policy will remain easy for a very long period, even as financial market participants have been incrementally moving forward their own assessments. It seems safe to say that, at least for now, financial market participants envision an earlier liftoff than indicated by the FOMC’s December dot projections.

Financial market participants have upgraded their economic outlooks and at the same time are beginning to wonder whether there might be too much policy stimulus in the pipeline. To be fair, the latter concern is probably more focused on the possibility of fiscal policy overkill given President Biden’s massive fiscal package than a clear conviction that the Fed is on the cusp of making a monetary mistake. Still, the chatter about the possibility of economic overheating or inflation has been unmistakable. In that sense, the 2021 Treasury market selloff is less a rerun of the 2013 taper tantrum and more like the “inflation scare” episodes of the 1980s, where bond markets became worried that the FOMC might be staying too easy for too long, creating excessive economic growth and inflation. The circumstances are, of course, quite different, but the events of the past few weeks smell a little bit like the old days of the Bond Market Vigilantes signaling to the Fed that it might need to rethink its dovishness. Regardless, it should be an interesting time for the economy, for financial markets, and for the Fed.

Stephen Stanley
1 (203) 428-2556

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