What the Coming Fed Taper Means for Bonds and Stocks

Other taper-worthy factors

Beyond hints from Fed members and robust economic data, banks and the money markets are encountering QE-related problems.

Banks are struggling to digest the reserves they receive when the Fed purchases assets from them. As a result, their ongoing ability to facilitate additional amounts of QE is increasingly becoming problematic.

Zoltan Pozsar, credit analyst and Fed expert at Credit Suisse, summed the situation as follows:

(The) use of the (reverse repurchase program RRP) facility has never been this high outside of quarter-end turns, and the fact that the use of the facility is this high on a sunny day mid-quarter means that banks don't have the balance sheet to warehouse any more reserves at current spread levels." (my emphasis)

The second problem facing the Fed is the recent reduction of Treasury balances held at the Fed. As a result, the Treasury is issuing fewer short-term bonds, resulting in a scarcity of money market securities and collateral supporting derivatives. Consequently, short-term interest rates are starting to go negative.

Those two problems make it progressively more challenging to maintain the pace of QE and keep rates from going negative.

QE, taper, and bond yields

With an understanding of my case for tapering, let's revisit how yields behaved during prior episodes of QE and the periods following QE.

The graph below shows the yield on 10-year UST notes rose during each QE period and fell upon its conclusion. As circled, yields fell precipitously when the Fed reversed QE via auantitative tightening (QT).

Ten-year yields rose about 1% from the start of QE to peak yield levels during QE. Equally important, yields fell toward the end of QE. The reason for peaking before QE ends is growing investor beliefs, at those times, the Fed was getting closer to tapering or halting QE purchases. The data is not available for QE4.

Yields are close to their cycle highs. If we believe the Fed is nearing tapering, yields could be peaking. Based on prior QE taper experiences, a yield decline of 1% or even more may be in store for the next six months to a year if the Fed is, in fact, on the doorsteps of tapering.

Similarly, the following graph compares the 2yr/10yr yield curve and the Fed's balance sheet over the same QE periods.

The yield curve and yield graphs look similar. Short-term yields were relatively constant during QE while long-term yields rose. In all three QE examples, the yield curve quickly flattened after QE ended.

Beyond Bonds

As confidence in the Fed reducing its pace of QE heightens, bond allocation and duration of bonds should increase. That said, we must also consider how other interest-rate-sensitive assets might do. Below we provide a similar analysis for financial stocks (XLF), preferred stocks (PFF), and MBS agency REITs (NLY).

The table below shows the returns of the three assets during QE and the six months following QE

Profits and/or dividends for the three assets are sensitive to changes in the yield curve. While not concrete, the assets did better during QE when the yield curve was steepening. On average, the three assets gained 28% during each episode of QE. Their performance was not as robust when the yield curve flattened after QE. On average, they fell nearly 2% during the six months following QE.

When the Fed begins to taper or even get more serious about tapering, be cautious with exposure to the three assets.

Inflation expectations

Top of every investor's mind is inflation. As such, it is worth sharing how market expectations for inflation changed during the four periods of QE.

As shown below, QE 1 was accompanied by a 3% spike in inflation expectations, albeit from negative territory. Likewise, QE 2 saw expectations rise while they fell during QE3.

Thus far, during QE4, they spiked by about 2.50%, like QE1, but starting from a higher level. Of note, implied inflation expectations are now above pre-pandemic expectations. The QE1 spike in expectations failed to clear prior expectations.

The Fed, via QE, makes this analysis incredibly difficult. As shown below, the Fed is an active buyer in the TIPs market, thereby distorting implied inflation readings. The indicator is not worthless, but it is flawed, making comparisons to the past more difficult. I offer caution when considering inflation expectations into your yield forecast.

Summary

I know it sounds crazy to stock investors when I say "fade the Fed." The stock market has taught equity investors to buy when the Fed is buying and be careful when they are not. What stock investors may not know is the poor performance of bonds during QE and their strong performance afterward.

Bond investors should sell when the Fed is buying and buy when they are selling.

The Fed is on the precipice of tapering its asset purchases. How and when it might accomplish that are big unknowns. However, it is coming, and there is a good amount of money to be made or not lost when the market senses the Fed is ready to change its tune.

Michael Lebowitz is the founding partner of 720 Global and partner with Real Investment Advice. We assist our clients in differentiating themselves from the crowd with a focus on value, performance and a clear, lucid assessment of global market and economic dynamics. For more information about our upcoming subscription service RIA Pro, please contact us at 301.466.1204 or email [email protected].

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