When the US Federal Reserve started talking about “tapering” its securities purchases midyear, financial market participants clutched their proverbial pearls.
Each period of financial market turmoil leaves an enduring impression on those of us lucky or unlucky enough to work on a bank’s trading floor. The thought of taper tantrum version two, and the stress associated with trying to make sense of a nonsensical market, is quite triggering. Many feared a market tantrum similar to that seen in May 2013. Yet the Fed started tapering this month, and financial markets have taken it in their stride.
“Tapering” made it into the financial lexicon in May 2013 when then Fed chair Ben Bernanke sent financial markets careening into the abyss when he said the Fed would “in the next few meetings, take a step down in [its] pace of purchases”. The Merriam-Webster dictionary defines “taper” as to “diminish or reduce in thickness towards the end”. The Fed was not implying that it would put a hard stop to balance sheet expansion, or that such a change would be soon. But in 2013 currency and bond markets reacted as if they had received a punch in the face from the Fed. In 2021, markets have stuttered but they haven’t collapsed. What should we read into this?
The biggest difference between the 2013 taper episode and the current one is the failure of real US rates to adjust higher as the Fed signalled and then started tightening.
In the three months after Bernanke’s testimony in May 2013, the real US 10-year rate rose by about 160 basis points, 100 points of this over just six weeks. This yield went from just below -0.5% to about 0.5% permanently. Now the real 10-year yield is at -1.16%, only a few points above the record low level of -1.2% it reached in early August. Real US rates are the dollar funding rates and thus arguably the base funding rates for most of the world’s economy. What is keeping real dollar borrowing rates so very low? Inflation.
Inflation expectations
When the Fed started talking about tapering, US inflation expectations were low and falling. Consumer inflation in the US was expected to be only 2% and inflation expectations fell precipitously over the remainder of 2013. At present US consumer inflation is forecast at 3.3% in 2022, and forecasts have been revised higher consistently over this entire year. Tightening monetary policy into rising inflation expectations keeps real borrowing rates stable — the Fed is not tightening enough to derail the reflation story.
The last time the beginning of US tightening coincided with rising inflation expectations was in 2004. Real US borrowing rates remained contained for a year after tightening started and emerging-market currencies were well anchored. Global growth was resilient, supported by Chinese growth and credit-guzzling US consumers. Eventually the credit-driven US housing bubble took the financial system under. Before that the US economy was slowing, but from a high rate, and a tighter policy stance was appropriate not only for the US but for many parts of the globe where credit growth was frothy.
Tapering should be understood as the beginning of the US’s tightening cycle. Jerome Powell has been at pains to explain that the Fed is not yet signalling that hikes are imminent, but that is neither here nor there. The argument between the hawks and the doves will continue, and whether tightening should pick up pace or slow down will be hotly debated. The room for policy error remains. Tighten too fast or too soon and global growth could be derailed. Take too long and the fallout could be acute.
However, sooner (as in 2013) or later (as in 2004) pain follows US monetary policy tightening. The globe seems to have missed a “taper tantrum” this time round. But a tantrum of some kind is still at best possible and at worst highly likely.
• Lijane works in fixed-income sales and strategy at Absa Corporate & Investment Banking.
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