The Big Idea

A different response to taper this time

| September 10, 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.

Despite the extraordinary role the Fed has played over the last 18 months, the market has shown almost no sign of concern much less distress at the prospect of tapering and a slow Fed withdrawal. In rates, volatility and most spread markets, it would be hard to point to signs that taper talk has led to tantrum. Experience with taper on the part of the Fed and investors likely explains some of it, and more benign implications of taper this time may explain some, too. The Fed still needs to lay out some key details, but most of the impact of taper at this point seems priced in.

It is impossible to pinpoint exactly when markets start to price in tapering, but there are indications of when the idea gets louder in the public conversation. Google Trends tracking of searches for “Fed taper” or “Fed tapering” show awareness today approaching levels last seen when the Fed leaned into tapering in 2013 (Exhibit 1). That action reflects a steady beat of remarks about tapering starting in January from Fed bank presidents, Fed governors, occasionally the Fed chair and the bubbling up of the topic in FOMC minutes and press conferences through the summer. That action presumably includes more than just fixed income analysts reminding themselves of Fed history.

Exhibit 1: Awareness of tapering has neared levels when the Fed last tapered

Source: Google Trends, Amherst Pierpont Securities

The market has not reacted to talk of Fed tapering the same way it did in 2013. In rates, volatility and credit, the reaction has been much more muted this year. Only in MBS is there a case for a reaction similar to the last time around, and it is not an open-and-shut case. Of course, these markets move to more things than just talk of Fed taper. But taper reflects a broad set of factors that shape Fed policy, and those factors do shape these markets. Something is different this time around.

The response in rates

On the front end of the yield curve, the market move this year is much smaller than 2013. In both 2013 and 2021, discussion of tapering got louder around May and June. In both years, 2-year Treasury yields moved higher, reflecting a higher expected path for fed funds (Exhibit 2). But heading in September 2013, 2-year yields kept moving up. In 2021, they have moved little beyond their early summer response.

Exhibit 2: A more muted 2-year Treasury response to taper talk this year

Source: Bloomberg, Amherst Pierpont Securities

On the longer part of the yield curve, the difference in response across episodes of taper talk is striking. In both 2013 and 2021, 10-year Treasury yields in early May stood near 1.60% (Exhibit 3). By early September 2013, 10-year yields had risen to nearly 3.00%. Today, 10-year yields stand near 1.35%

Exhibit 3: A clear difference in 10-year Treasury response to taper talk this year

Source: Bloomberg, Amherst Pierpont Securities

The response in volatility markets

In the options markets, which price uncertainty every day, there is little sign of new concern as taper talk has ramped up this year. That was not the case in 2013. From early May to early July of 2013, implied interest rate volatility almost doubled (Exhibit 4). From early May to early July of 2021, on the other hand, implied interest rate volatility is almost unchanged and has remained roughly unchanged since then.

Exhibit 4: Little response in implied volatility to taper talk this year

Source: Bloomberg, Amherst Pierpont Securities

The response in spread markets

In investment grade corporate debt, the response to rising taper talk also has been relatively muted. There is a big difference in absolute IG spreads between 2013 and 2021, with spreads this year roughly 30 bp tighter (Exhibit 5). But from mid-May 2013, around the time Fed Chair Ben Bernanke famously tipped his hand to taper, to early July, corporate spreads widened more than 20 bp. In 2021, corporate spreads widened as interest rates rose through February, but they have since returned to pre-February levels and remained relatively steady.

Exhibit 5: Investment grade corporate spreads have been steady since March

Source: Bloomberg, Amherst Pierpont Securities

Only in agency MBS this year is there a rough parallel to the market response of 2013. In both years, the OAS on par 30-year MBS has widened around 20 bp since taper talk picked up in May and June (Exhibit 6). One possible explanation for the unique weakness in MBS is that the Fed and banks through the latest round of QE have been the only net buyers. In rates and corporate debt, demand has been much more diversified. As the Fed backs away, and as the flow of deposits and bank need to invest slows, MBS is particularly at risk.

Exhibit 6: MBS has widened this year as taper talk has picked up

Source: Bloomberg, Amherst Pierpont Securities

The things that might be different this time

One possible reason markets have responded so placidly to taper talk is that both the Fed and the market have done a better job this time explaining and understanding taper. In 2013, tapering was a new and untested idea. Neither the Fed nor investors knew how open-ended QE ended. Investors had to consider the possibility that the Fed would simply stop buying or actually sell assets rather than bringing QE to a gradual end and then maintaining SOMA balances. The sequencing of an end to QE and a fed funds hike also was new. Fed communications allowed the uncertainty around these issues to seep into market pricing. In 2021, the possible parameters of tapering—timing, amount, asset mix—are more limited. The sequence of taper-first-hike-later is established. The Fed intentionally allowed the conversation about tapering to slowly build this time to avoid surprising investors. In many respects, the broad elements of tapering have been priced in since QE began.

Another possible reason markets seem so blasé is that other factors make the impact of tapering less consequential this time around. In 2013, the health of the financial system and the broader economy after the 2008 crisis was still fragile. Banks were just at the beginning of building capital and liquidity. Home prices had not yet returned to 2008 levels, many consumers had blemishes on their credit and mortgage lending standards had become historically tight. Banks and consumers today are much stronger. And beyond the economy, both monetary and fiscal policy seem much more likely to respond to any stress created by taper.

A final possible reason for the market’s muted response could be that the market thinks the Fed ultimately will not taper. This seems highly unlikely.

At this point, it is hard to imagine circumstances now that could trigger the initial sky-is-falling response of the market in 2013. The Fed still has to lay out the timing, amount and mix of taper and guide expectations about hikes after QE is done. But those parameters amount to a relatively limited set of possibilities. For the most part, tapering is priced in. It is time to start thinking beyond taper to the other elements of the economy and monetary and fiscal policy that could shape rates and spreads.

* * *

The view in rates

Fed RRP balances closed Friday at record $1.1 trillion. Balances have topped $1 trillion since August 11. The rate on the RRP is still attractive relative to other forms of repo and beats the yield on T-bills out to early November.

Settings on 3-month LIBOR closed Friday at around 11 bp. LIBOR has started pricing in the transition to SOFR. Most interdealer swap trades will use SOFR by October at the latest, with regulators urging no new LIBOR exposures after the end of this year. LIBOR officially sunsets on June 30, 2023.

The 10-year note has finished the most recent session at 1.34%, up from mid-August levels. Breakeven 10-year inflation is at 240 bp, within its range since June. The 10-year real rate finished the week at negative 105 bp, also within its range since June.

The Treasury yield curve has finished its most recent session with 2s10s at 113 bp. The 5s30s curve has finished at 112 bp.

The view in spreads

Credit continues to broadly outperform MBS. Benchmark investment grade cash spreads now stand around 89 bp, roughly their same level at the end of May. Demand from mutual funds, international portfolios and insurers looks healthy. Low rates should continue supporting corporate balance sheet strength. Ratios of EBITDA to interest expense are in the middle of the range despite high ratios of debt to EBITDA. Investor demand for yield should keep spreads relatively tight. A strong economy should help credit spreads, but relative value flows at money managers could still soften credit spreads if MBS gets wide enough.

MBS is finishing Friday in good shape. The prospect of Fed tapering and heavy net supply should keep weighing on MBS spreads until the Fed shows its hand and the market can price the impact. The market has already priced additional risk of soft demand and steady supply, with the nominal spread of par 30-year MBS to the 7.5-year Treasury at 72 bp, wider from the end of May by 10 bp. However, that is 5 bp better than mid-August. Spreads look vulnerable to going still wider as the Fed likely leans into tapering or tapering-and-hiking faster than its 2013-to-2015 cycle.

The view in credit

Fundamental credit looks strong and generally continues to improve, helped by Covid reopening and low rates. However, some credits will have to slowly adjust as the Fed slows the flow of liquidity into the market. Consumers continue to look strong with equities and real estate higher and still historically low. Consumers have not added much debt. Corporate balance sheets have taken on more leverage, although mitigated by strong cash balances and low interest costs. EBITDA-to-interest-expense is at healthy levels. Strong economic growth in 2021 and 2022 should lift most EBITDA and continue easing credit concerns. Eventually, rising interest expense in 2023 should compete with EBITDA growth. Fundamental credit should hinge on whether the Fed can orchestrate a soft landing as it starts to tighten financial conditions.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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