Market Blog Posted by lplresearch
Tuesday, May 18, 2021
After the April consumer price index (CPI) release that surprised to the upside, indicating consumer prices in some areas of the economy are increasing at a faster pace than many expected, the discussion has shifted to the need for the Federal Reserve (Fed) to potentially normalize monetary policy earlier than they’ve indicated. While we still think the Fed will wait until some of these noisy economic data points have passed to provide clarity on policy normalization, we believe the discussion around tapering will continue to be an important financial story.
What is tapering?
In the immediate aftermath of the pandemic-induced economic shut-downs, the Fed effectively cut short-term interest rates to zero and reinstated a number of bond buying programs to help provide liquidity and financial stability to markets. While a number of these programs have expired, the Fed continues to buy $80 billion of Treasury securities and $40 billion of mortgage-backed securities (MBS) every month. Moreover, the Fed has indicated a willingness to continue to buy bonds in the stated amounts until “substantial further progress” has been made towards full employment and price stability (inflation).
Some have argued that, given the CPI report in particular, substantial further progress has already been made on inflation and the economy is at risk of “running too hot.” Therefore, the Fed no longer needs to support markets and in fact is adding to financial instabilities by continuing to provide unneeded liquidity. Thus, the argument is that the Fed should start to reduce (taper) the size of these bond purchases sooner rather than later.
“The Fed is in a difficult situation right now,” according to LPL Financial Fixed Income Strategist Lawrence Gillum. “Withdrawing policy support too soon may hamper the economic recovery but waiting too long may cause the economy to run too hot. We think the Fed will be patient before reducing bond purchases but their job is getting tougher.”
Why is tapering important?
As seen from the LPL Research Chart of the Day, the Fed’s balance sheet has grown tremendously over the past year with the central bank now owning over $7,000,000,000,000 of Treasury and mortgage securities. Certainly, the buying behavior of the Fed has helped support the Treasury and mortgage markets and has kept yields and mortgage spreads low. As the Fed reduces its purchases, though, we would expect yields and mortgage spreads to incrementally increase due to the removal of support. As yields increase, mortgage and other borrowing rates would likely increase as well and potentially slow down consumer activity.
Our base case is the Fed will continue to follow the stated bond buying program for the remainder of the year, and then incrementally curtail purchases throughout 2022. This should continue to help support the Treasury and MBS markets and help digest the record amount of Treasury securities expected to come to the market this year.
That said, there is a growing chance that the Fed will start to reduce its purchases of MBS this year as more attention has been paid recently to the ongoing strength of the housing market. Indeed, the continued purchases of MBS have likely added to the increases in home prices this year. Nonetheless, withdrawing policy support should signal the Fed believes that the economic recovery is well underway and that markets can function on their own, which are clear positives, in our view.
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