MARKET COMMENTARY

Boiling Frogs, Balance Sheets, and Powell’s Tale of the Taper

09.30.2021 - Jeffrey S. MacDonald, Head of Fixed Income Strategies

The old story goes that if you put a frog in a pot of tepid water and gradually turn up the heat that the frog will never react to the increase in water temperature. Rather than hop out the frog will simply sit there until the heat of the water rises to a point that marks the end of the frog.

The Federal Reserve is preparing to turn up the heat on its own frog by tapering the current $120 billion of monthly bond purchases in its Quantitative Easing (QE) program. The growing consensus among Federal Open Markets Committee (FOMC) members is that as long as the policy heat of tapering rises gradually, the markets should sit tight through the transition. The trick is that the pace of the taper needs to be gradual enough to avoid alerting our monetary frog, which would cause a “hop-out” from risk and credit assets, potentially leading to unwanted stresses in financial conditions.

The Federal Reserve has a dual mandate when it comes to setting monetary policy: full employment and price stability. While the latest assessment from the Fed suggests that the criteria to satisfy their price stability mandate have been met, the Fed believes labor markets still have a way to go. Powell and the FOMC must also be careful not to turn the heat up on the frog to such a degree that financial conditions would tighten to the point where monetary policy begins to threaten the Fed’s ability to satisfy its dual mandate. This is not exactly an easy task given the amount of monetary accommodation that has been introduced since the beginning of the COVID-driven shutdown of the global economy in 2020.

The Fed’s Complex Balance Sheet

In many respects, the Fed’s balance sheet resembles the standard dual-entry bookkeeping one would see across corporate America. Assets line up in a column on the left and liabilities line up in a column on the right. Throw in a little shareholder’s equity (if there is any) and both sides should match when totaled. Yet, that’s where the similarities end.

On the asset side, the Fed holds predominately the bonds and financial obligations of government borrowers. Most of these holdings are US Treasuries and US Agency mortgage-backed securities (MBS). The balance consists of loans to banks in the repurchase market (a form of short-term borrowing for dealers in government securities) and other securities associated with specific open-market operations programs.

The Fed’s liabilities are essentially the US dollars out in circulation. The Fed can buy assets to inject dollars into the system or sell assets to reduce dollars, thereby using this as a monetary policy tool helping to achieve its’ goals depending on economic conditions.

The use and composition of the Fed’s balance sheet as an active policy tool increased meaningfully during the Great Financial Crisis, nearly tripling in size to $2.25 trillion from 2007-2009. The COVID-19 shutdown once again kicked the balance sheet into high gear as emergency policy measures provided support to multiple sectors of the US economy. This ballooned the asset side of the Fed balance sheet to over $8 trillion. Of those emergency measures the Fed balance sheet supported, only the $120 billion in monthly bond purchases; $80 billion in US treasuries, and $40 billion in Agency MBS are left.

Our Frog stays put and lives to hop another day

FOMC members now largely agree that the time has come to begin to wind down the emergency measures of the QE program and begin to “taper” the monthly $120 billion in purchases. Fewer purchases mean less accommodation going forward and consequently some warmer water could be in store for our frog. We think our monetary frog, along with market and economic fundamentals, will successfully weather these changes in monetary policy for the following reasons:

  • Market Conditions. The intention of the Fed’s change in its QE program is to purchase less bonds moving forward; it has not communicated a plan to begin to sell If the pace of tapering is set at a reduction of $15 billion per month ($10 billion Treasuries and $5 billion MBS), the Fed will still actively purchase a combination of US Treasuries and MBS well into 2022. Powell’s comments at the September press conference following the conclusion of the FOMC meeting supported this timeline with the expectation that the taper should be completed “mid-year” in 2022. Although the balance sheet will take years to normalize—even in the face of zero additional purchases—the money supply will remain high and will continue to support the Fed’s dual mandate. The Congressional Budget Office (CBO) in its budget outlook also recognizes that the high levels of deficit spending that financed COVID-related fiscal support should moderate as the impact of the virus wanes. The slower rate of net borrowing at the Federal level should provide some offset to the upcoming reduction in Fed purchases.
  • Communication. In 2013, in testimony before Congress, then Fed Chair Ben Bernanke let slip that if the economic recovery continued its current trajectory, a reduction in balance sheet purchases would be appropriate. These comments surprised markets and led to the “Taper Tantrum” in which yields spiked aggressively in response. Jay Powell was an FOMC committee member at that time and we believe the lessons learned in 2013 have translated into the protracted communication program leading up to the current tapering discussion. Forward guidance as a policy tool has all but eliminated any element of surprise that the upcoming taper announcement would cause. We also find it central to the FOMC’s messaging that the tapering of purchases and the hiking of the Fed Funds rate are not sequentially linked. We believe the decision to taper and the decision to raise the Fed Funds rate are two different policy decisions with a much stricter set of criteria driving the latter. While current Fed estimates suggest rate hikes in late 2022 or early 2023, we believe the fundamental conditions that would drive such a decision have not yet been met.
  • Funamentals. The US economy is still quite strong, despite softer economic data and a rise in Delta variant cases. Interest rates should remain low as it appears that earlier fears of a runaway inflation spike seem to have faded in favor of the Fed’s view of transitory pressures related to supply bottlenecks and other drivers that should continue to fade over time. The strength of housing activity has been consistent and does not appear to need the additional mortgage support that the Fed purchases have targeted. With progress on the control of the Delta variant and record job openings, the fundamental outlook for 2022 appears ready to weather the wind down of the Fed’s current asset purchases.
Our Outlook Remains Favorable (…a look inside the pot)

We recognize that these asset purchases were always designed to be emergency measures aimed at addressing an unprecedented shutdown of the US economy.

But now, with fundamentals strong, liquidity solid, and the economy’s ability to better manage the impact of COVID-19 moving forward, we remain positively biased towards risk assets like stocks and credit. While we believe longer maturity rates should be higher than they are now, we do not envision an environment in which an aggressive rate increase spooks investors or becomes a drag on economic growth, even in the wake of the impending taper.

The taper remains a necessary step in the normalization process and our view is that the sooner it begins the sooner that market participants can move on. Our frog looks happy enough in the pot right now and it seems that the majority of the FOMC members favor a near-term start with a very gradual pace of purchase reductions, which should suit our frog just fine.

 





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