Tapering: what is it and why should you care

What does tapering mean?

When Federal Reserve's members talk about tapering, they refer to the gradual slow down of the pace of its large-scale asset purchases. Thus, it's talking about reducing the Fed's balance sheet's expansion pace,  also known as Quantitative Easing (QE).

The subsequent step to tapering is considering whether to reinvest maturing securities or to reduce its balance sheet. The central bank can decide whether to reduce its balance sheet gradually by letting maturing securities “runoff” without reinvesting or to sell assets actively.

What is Quantitative Easing (QE)?

QE refers to central banks' asset purchase programs created to stimulate the economy. It is a form of monetary policy used to increase the domestic supply of money and spur economic activity.

Central banks turn to quantitative easing when the short-term interest rate plunge to zero, but the economy still needs support. The idea behind QE is that it helps the economy by reducing interest rates and making corporate borrowing and mortgages cheaper. By buying government debt and Mortgage-Backed Securities (MBS), the central bank reduces these instruments’ supply in the broader market. Investors who decide to hold these instruments need to raise their bids, pushing yields down.

In the wake of the Covid pandemic, the Federal Reserve cut short-term interest rates to zero in March 2020. Starting from July 2021, the Federal Reserve has been buying $80 billion of US Treasuries and $40 billion MBS to stimulate the economy to ensure a fast economic recovery.

Is QE different today compared to other times in history?

Currently, the Fed is purchasing Treasuries across a broad range of maturities to mitigate the shock provoked by the COVID-19 last year. However, QE before was involving long-term maturities. Therefore tapering could impact the yield curve differently.

Why is the Federal Reserve looking to reduce the pace of asset purchases?

The simple answer to this question is: because the economy doesn't need stimulus any longer. The US economy is estimated to grow an eye-popping 6% this year and 4% next year. At the same time, inflationary pressures and excessive risk-taking in markets accelerated significantly, making the termination of QE a natural outcome. However, Jerome Powell has recently highlighted that "substantial further progress" is needed to begin tapering. These remarks can be linked to the central bank's full employment target. The Fed is looking at the pre-COVID unemployment rate, roughly 3.5% and set it as a target. Although the central bank commits to full unemployment for a noble cause, the risk here is that the economy overheats, and its QE program continues to stimulate inflation.

What is a “taper tantrum”?

"Taper tantrum" refers to a particular episode that happened in 2013.

Following three rounds of QE to stimulate the economy after the Global Financial Crisis (GFC), Fed's Chair Ben Bernanke prepared the market for a decrease of purchases in May 2013. The following month, he revealed a tapering plan. Yields rose from 2.2% to 3% during summer despite Bernanke and other Fed members emphasising that any reduction would be gradual and not be related to any interest rate hikes. The sudden increase in US treasury yields caused capital outflows and currency depreciation in emerging markets like Brazil, India, Turkey and South Africa.

Regardless, the central banks began to taper in December that year, reducing the pace of asset purchases by $10 billion per month, starting from $85 billion. The asset purchase program ended in October 2014. The Federal Reserve, led by Janet Yellen, began shrinking its balance sheet a year later.

Can tapering in 2021 provoke another “taper tantrum”?

Compared to 2013, Jerome Powell has tried to decouple tapering talks with interest rate hikes this year. Indeed, he stated clearly said that tapering will precede any rate hike consideration.

Additionally, tapering doesn't mean that the Fed's balance sheet is going to shrink anytime soon. It will continue to grow (although at a slower pace) until tapering ends, thus providing stimulus to the economy. Under this point of view, tapering shouldn't be a big game-changer for the bond market.

Yet, tapering gives a signal surrounding the central bank's future policy intentions, impacting long-term interest rates. Expectations of less accommodative policies can spur a selloff in the long part of the yield curve before the Federal Reserve even begins to contemplate shrinking its balance sheet.

It's also important to highlight that tapering may be introduced in the last quarter of the year, where we might see the reflation trade come back to life as growth and inflation continue to be supported.

In conclusion, we might not run into a taper tantrum, such as it happened in 2013. Still, the rise in yield may be explained by economic fundamentals and accelerated by the Fed's monetary policy intentions.

Why reducing the Fed’s balance’s sheet size can be more problematic than tapering?

Because it increases the asset supply in markets while demand remains unchanged, it could provoke a rise in yields, thus tightening economic conditions.

Since the Global Financial crisis, the Federal Reserve decided to slowly wind down its balance sheet only once from October 2017 until September 2019. However, it didn’t end up well.