The Big Conversation
Episode 88: Time for another taper tantrum?
This week we look at the potential impact on risk assets if the Fed were to announce a tapering of their bond purchases in the next few weeks. Many investors are using the 2013 taper tantrum as the blueprint, but the market today is a very different beast, and the outcome could surprise the hawks. The biggest risk would appear to be a squeeze higher in nominal and real yields, but that very risk may end up capping yields either via weakness in other assets creating a flight to safety or from a rapid U-turn from the Fed.
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Roger [00:00:00] In 2013, the announcement by the Fed that the rate of QE bond purchases would begin to slow, led to the now infamous 'taper tantrum', which saw a big spike in bond yields, well in advance of the actual slowdown in bond purchases. Taper talk has again been a hot topic throughout this summer, with many looking at this week's Jackson Hole conference for guidance. Should we expect markets to react the same way that they did in 2013? Well, that's today's Big Conversation.
[00:00:30] The Fed has been buying bonds at a monthly rate in excess of 100 billion dollars. Every time there's a wobble in asset markets, a Fed spokesman is usually quick off the mark with soothing words about the flexibility of their efforts. They're therefore likely to approach a tapering of the current QE program with equal caution. But given the overshoot of inflation measures, hawkish observers have put a high probability that the Fed will announce a taper as soon as the next FOMC meeting on September the 22nd. They may use the annual Jackson Hole symposium at the end of this week to outline their thinking. The difficulty in making any decisions in the current environment however, was again laid bare by the fact that as of last Friday, this event is now going to be online for the second year in succession because of the spectre of the Delta variant of Covid. We must also remember that an announcement of the taper is obviously not the same thing as the actual taper. In the next few weeks, they could still outline a path towards fewer bond purchases whilst remaining extremely flexible about the actual commencement of a taper. As we've already seen, most of the market action during the taper tantrum of 2013 took place before the rate of bond purchases began to slow. The US 10-year yield nearly doubled, rising from one point six five percent to just under three percent in the initial bond rout. Emerging markets saw outflows in both bond funds and equity funds, the latter significantly underperforming the U.S. equity market, whilst the S&P 500 hardly blinked. The dollar was also edging higher during that early part of the taper tantrum, and that didn't help emerging market assets either. In fact, most of the problems that arose during the actual taper period during 2014 resulted from the QE efforts of the Bank of Japan and the ECB, who stepped into the breach vacated by the Fed and inadvertently caused the dollar to surge, leading to a collapse in commodity prices and a global profits recession across the industrial sector. This eventually led to the so-called Shanghai Accord in February 2016 to help stabilize the dollar, or at least stabilize the speed of its moves. And central bankers have been keen to cap volatility in all assets ever since. But how should we expect markets to react if there was a taper announcement today compared to what happened in 2013? Should we use the taper tantrum as a blueprint or have markets and central bankers learnt something from that experience? For holders of gold, one of the key considerations will be the direction of real yields, which is the nominal or actual yield minus inflation expectations. Gold has an inverse relationship with real yields, so that when real yields rise, gold tends to fall. In 2013 real yields rose from around minus 75 basis points to a positive 90 basis points. And this helped fuel the decline in gold that was already underway. Today real yields are starting from slightly lower levels of around minus 100 basis points, but those upside risks are very clear. The main difference today is inflation, both actual and expected. Ten-year inflation expectations today are about the same level they were prior to the taper tantrum of 2013. Today's level, however, was preceded by a sharp rally in those expectations because the market started to price for the impacts of fiscal policy. During the 2013 taper tantrum, inflation expectations fell. Given how acute today's concerns about inflation are, these inflation expectations could fall even further on this occasion. So there's obviously a lot of risks for gold, but the market is far more prepared today. Furthermore, the Fed will be watching the bond market closely. There remains that lingering threat of yield curve control, and some argue that the Fed wants a steeper yield curve anyway, which would benefit banks. But if a taper announcement did cause an adverse reaction in the bond market, they could offset that by a specific targeting of yield levels. Whilst QE aims to buy a specific amount of assets on a monthly basis, yield curve control is there to basically cap yields at a specific level. And if successful, the mere threat of this policy can keep yields hovering around target levels with only the minimum of central bank activity. And if a surge in yields destabilizes the equity market, then the rise in bond yields would probably be very short-lived as risk-off environments usually then see bond rally and yields fall. Therefore, the long end of the bond market in 2021 and 2022 may not have as much scope to move as wildly as it did in 2013. Indeed, today's bond market may have been giving false signals about reflation and growth anyway. We've noted in previous episodes that the US 10-year yield peaked at the end of March. Morgan Stanley analysts have noted at the time that most of the selling pressure in the bond market was taking place in the overnight session when Japanese investors would have been active. The rise in bond yields may have been nothing more than an asset allocation out of bonds and into equities by the largest state pension in the world. At the time, the rise in yields was seen as confirmation of the reflation trade, but it ended abruptly at the end of Japan's financial year. Since then yields have fallen, and this has been interpreted as a decline in growth prospects due to a surge in Covid outbreaks. But again, Morgan Stanley points out that Japanese asset allocators have again been busy buying back into the bond market, with a majority of buying activity again seen in that overnight session, whilst European and US sessions have been seeing selling pressure. Add this to the lack of bond issuance because of the US government drawing down its cash funds from the Treasury General Account and the fall in bond yields over the last quarter could again be technical rather than fundamental. With cash levels now having normalized in the general account, the bond market may again be susceptible to sudden surges in yield, and therefore more sensitive to the announcement of a potential taper. But I think that the threat of yield curve control and the decline in inflation expectations could limit the upside in both nominal and the real yields compared to 2013.
[00:06:19] But what about the equity market? US large caps have been making new high after new high. And perhaps most surprising is the outperformance of the US market versus emerging markets, which has accelerated over the last three months. Part of this is obviously reflecting the impact of Chinese policymakers on the large tech behemoths in China, with significant underperformance of China tech versus the Nasdaq over this period. The U.S. also benefits from having the largest concentration of passive flows of any major market. Fundamentals have become secondary to technical factors, and this has helped to generate a never-ending inflow into many US indices, regardless of underlying economic and profit-based considerations. In many ways, this should also help protect the US market from a surge in yields. We've already touched one point seven five percent on the US ten-year already in 2020, and this led to rotations out of tech and growth stocks into value plays such as industry and banks, but it didn't lead to instability in the broader market. Higher yields do remain a risk, as we saw when yields popped the equity rally at the end of 2018. But again, the threat of yield curve control can cap that risk. For the US 10-year yield, the 50-day moving average could be about to cross down through the 200-day moving average. On four of the last five occasions that this happened, it led to significantly lower yields, although about half of the speculative shorts in the futures market have now already unwound. Where the equity market has become a little bit more vulnerable is with the influx of retail investors over the last year. The dot com bubble twenty years ago was dominated by retail investors, and that bubble took three years to unwind. Since the Great Financial Crash of 2008, nearly every sell-off has seen an equally rapid rebound. But the new retail community has largely been untested since the lows of 2020. Again there are differences today. Retail investors have been using passive instruments such as ETFs to express their views, or are using the option market for directional bets. Nearly all the many pullbacks over the last few months have taken place in and around the monthly options expiry, which takes place on the third Friday of each month. Overall however, we have had a decline in realized volatility, and that's the actual volatility of an asset. Actual volatility on the S&P 500, out from 30 days to 100 days, has been converging on around 10 percent. Now, compare that to the VIX, which is in the high teens or even a three-month, 95 percent put option, which is close to 20 percent implied volatility. And we can see the buying protection against a broad-based equity pullback isn't cheap. Furthermore, the VIX curve is upward sloping, and that means that longer dated volatility is much higher than the current index. Therefore, there's no easy way to hedge via the options market unless you're looking at selling stocks and replacing them with an index call, because skew, which is the difference between the downside and the upside, is still very high. Out of the money index calls are generally trading on a much lower volatility than the equivalent out of the money puts. So overall, because there's so much more focus on the potential for a taper today, it feels like the outcome won't be as extreme as it was back in 2013. Consumer confidence has started to take a battering because high prices are now affecting demand. In fact high prices could be an antidote to high prices if it impacts consumers. Bond yields could therefore be capped by this, or they could be capped by the threat of yield curve control or by a rapid reversal from the Fed if their attempts at normalization cause bond yields to move too quickly.
[00:09:33] Emerging markets will continue to struggle whilst China's regulators turn the screw on tech companies with the additional threat that the recent break higher in the US dollar index could start to gather pace. This could be a variable that central banks struggle to control, though it needs a surge in the dollar to really create serious problems. The nature of the US market has changed significantly since 2013 due to the increasing importance of those passive funds. But as we've seen on many occasions, the US market is still susceptible to short, sharp corrections, many of which will take out investors stop losses. And there's no easy way to ride that out unless you can hold out for the long term in anticipation of another Fed rescue. And ultimately, that's the key variable. They've stepped in almost every time there's been an accident. Sometimes that's been of their own making, but they have become very adept at flip-flopping their policy response to suck volatility out of the market. Today it would be very unusual for them to ditch this policy response. Therefore, should we expect another tantrum or could the taper announcement when it comes actually end up being a bit more of a whimper? If you've got any questions about this episode or any others, please do put them into the comments section and we'll hopefully answer them in any future episodes.