Article written by Hamish Pepper, Harbour Asset Management – 1st September 2021

• As the US economy continues to improve, the US Federal Reserve (Fed) seems close to reducing its pace of bond purchases as part of its quantitative easing (QE) programme.
• Different to the “taper tantrum” of 2013, however, a reduction in purchases is widely expected and is not being associated with imminent interest rate hikes.
• US Treasury bond returns tend to be mixed prior to interest rate hikes but US equity markets generally fare much better.
• That’s not to say it will necessarily be smooth sailing for financial markets. Risks exist in many directions, but a well broadcast tapering may not be the largest concern.

We think the Fed is close to reducing, or tapering, its pace of bond purchases as part of its quantitative easing (QE) programme. The Fed is currently purchasing US$120bn of US Treasury and mortgage-backed securities every month. In a speech at the annual Jackson Hole Economic Symposium last week, Fed Chair Jerome Powell highlighted that the US economy had made “clear progress” towards maximum employment. The Fed has stipulated that “substantial further progress” towards its dual objectives of stable prices and maximum employment is needed to start reducing monetary stimulus. With that condition clearly met for inflation, recent focus has been squarely on the labour market.

The US has replaced almost three quarters of the jobs lost following COVID-19. Recent job growth has been vigorous, averaging more than 800,000 jobs per month since May 2021. Economists expect this pace to have continued in August. Economic growth continues to be supported by an ongoing vaccine rollout allowing re-opening and for households to deploy the large amount of savings accumulated since COVID-19 hit. The US economy is estimated to be currently growing at an annualised rate of 7%. With potential GDP growth around 2%, spare capacity is quickly being removed – paving the way to more persistent inflation pressure and higher interest rates.

This is not 2013. Many investors will remember the May 2013 “Taper Tantrum” caused by, then Fed Chair, Ben Bernanke’s unanticipated signaling that asset purchases would be reduced at some point in the future. In the month that followed, US 10-year Treasury yields increased more than 0.5% and the S&P 500 dropped almost 6%. The current situation differs in two important ways:

1. The market widely expects tapering to soon be announced, most likely at the Fed’s 23 September meeting; and
2. Tapering is not being associated with imminent interest rate rises, something Powell endeavored to emphasise in his Jackson Hole speech. Most analysts anticipate asset purchases to be wound down over the next 12-15 months and rate hikes to begin around the end of 2022. Markets price a 60% chance of a 0.25% interest rate rise at the December 2022 meeting.

US Treasury bonds returns tend to be mixed prior to interest rate hikes but US equity markets generally fare much better. In the 12 months prior to the beginning of the past four Fed tightening cycles, the average total US Treasury return was less than 2%, while US equities increased more than 10% (see chart below). In the 9 months prior, US Treasury returns were flat, on average, versus an average 10% gain for equities. In the final 6 months prior to the first hike, US Treasuries lost about 1%, on average, while equities gained 2%.

That’s not to say it will necessarily be smooth sailing for financial markets. The charts below show the wide spectrum of outcomes experienced around the beginning of previous Fed tightening cycles. Currently, risks exist in many directions, but a well broadcast tapering may not be the largest concern.

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