Federal Reserve Policy Update: The Tapering Dance Begins


Kevin Gale, Managing Director, Head of Fixed Income

The Federal Reserve is taking a (micro) first step towards tapering one of its accomodative policy tools by announcing on June 2, 2021 that it will begin to unwind its corporate bond portfolio. The portfolio consists of $5.2 billion of single name Investment Grade bonds and $8.6 billion of Investment Grade and High Yield ETFs. Given the relatively small size of the portfolio and the still high demand for credit, we would expect this to be an orderly unwind and have minimal impact on the overall credit markets.

By way of background, the Fed began purchasing ETFs in May of 2020 and individual corporate bonds in June of 2020. ETF purchases ceased by the end of July and no additional individual credit purchases took place after December 2020. The individual security purchases were all within 5 years to maturity (2025). AT&T, Comcast and Verizon are the three biggest positions the Fed owns, each consisting of about $100 million of securities on the Fed’s balance sheet.

The bottom line is that this should have minimal impact on the bond market, in our view, given the small size of the portfolio. However, this likely is just the beginning of the Fed’s tapering. As of now, the Fed is still purchasing $120B per month of Treasury and mortgage-backed securities (MBS). We expect the Fed to begin that taper talk by the end of the summer and begin slowing their monthly purchases shortly thereafter.

What will the bond market’s reaction be when the Fed does begin to taper? During the “taper tantrum” of 2013, the 10-year Treasury yield rose from 2.0% to 2.9% as investors sought to get in front of the Fed’s selling. During the same time period, however, the S&P 500 index rose 10.7%. Volatility in the stock market is always a possibility, but it is important to remember that taper talk is on the table because, generally speaking, the economy is strengthening and requires less policy support.

One thing to note is that while the 10-year Treasury was at 2% when the taper talk began in 2013, it initially fell to around 1.7% before beginning its ascent in the following months and by 2016, the 10-year was back under 1.5%, so runaway rates are not a sure thing. We do believe that initially, the market is more prepared for the taper this time around as expectations for it are increasing by the day given economic conditions and inflation pressure. This will likely lead to modestly higher yields in the long end of the yield curve but, in our opinion, the nearly 100 basis points (1%) increase we saw during the 2013 taper is not as likely. In our view, the inflation outlook will likely have a bigger impact on yields this time around.

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