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The Fed’s options to respond to this ‘taper tantrum’

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Mark Allan
 

The sell-off in the US Treasury market has accelerated over the last few days and now has an increasing number of parallels to the experience of the 2013 ‘taper tantrum’.

As was the case then, the rise in bond yields has infected the front end of the yield curve to the extent that at one point on Thursday, an entire 25bp policy rate rise by the US Federal Reserve had been priced in in 2022 futures (see exhibit 1), several further interest rate increases were discounted for 2023 and more in the years beyond.

exhibit 1 ENG

Up to now, the message from Fed officials has been that the repricing in the US fixed income market is not a concern. Officials have argued the US economic outlook is brighter now thanks to the rollout of vaccinations and (the prospect of more) fiscal stimulus. In this way, they have implicitly endorsed part of the rise in US interest rates.

Gap between market rates and Fed forecasts

The latest market moves, however, have been much more aggressive. Market pricing is currently starkly different from the (admittedly now well out-of-date) December 2020 ‘dot plot’ (see exhibit 2).

Exhibit 2: Here is what US Federal Reserve policymakers in December 2020 expected the Fed funds rate (the main central bank policy rate) to be over the 2020-2023 period – graph shows that most central bankers did not foresee a change in rates by 2023 (‘dot plot’; midpoint of target range in %)

The Fed's options exhibit 2

Source: US Federal Reserve; Dec 2020

One particularly notable feature is that inflation breakevens have moved lower. That can be seen as an indication that market pricing is starting to become inconsistent with the Fed’s new average inflation target framework. Given that, further moves of the size seen on Thursday will likely start to worry the Fed.

Options to intervene verbally

Should Fed officials want to pull the market back down, they have an escalating series of options:

  1. Brief the media off the record ahead of the Fed blackout window that starts at the close of business on 5 March; explain that policymakers expect only (very) small changes to their inflation and interest rate projections which are due to be published at the mid-March policy meeting.
  2. At the March meeting, use the new economic forecasts, the ‘dot plot’, and chair Jerome Powell’s press conference to hint strongly that the Fed’s bond purchases will not be tapered in 2021.
  3. Send a senior policymaker (most likely either Clarida or Williams) out for a television interview next week with the deliberate intent of talking the market down.
  4. Use the mid-March policy statement to provide clear guidance that the Fed will not taper its quantitative easing programme of bond purchases in 2021 and state that the taper itself will take almost an entire year, which would (implicitly) rule out rate increases in 2022.

We are keeping a close eye on the bond market outlook and the responses from key central banks in other developed markets to what is happening.

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