The US Fed began reducing its asset purchases at the start of this year. Monthly purchases of US treasuries have so far been cut from US$45 billion to US$25 billion and purchases of mortgage-backed securities from US$40 billion to US$20 billion. Asset purchases are likely to cease entirely by the end of the third quarter.
The tapering process has so far produced surprising results in the movements of key financial assets. Tapering was widely expected to push up bond yields and push down share prices, but this not happened. Instead, since the start of 2014, 10-year government bond yields have dropped by some 50 basis points to 2.5 percent while the S&P 500 is up 2 percent. What’s going on?
Several factors seem to be behind the sharp decline in bond yields.
Low inflation and inflation expectations: Inflation as measured by the core personal consumption deflator is running at just 1.2 percent. Long-term inflation expectations have declined to 2 percent from 2.5 percent a year ago, measured by the difference between conventional and inflation-linked 10-year bonds.
Fed forward guidance: The Fed’s dovish recent attitude has seen one-year interest rates decline since the third quarter of last year. The market has pushed away expectations of Fed rate hikes.
Contracting Treasury supply: The US budget deficit has contracted rapidly over the last year, falling from 9 percent of GDP in 2012 to around 6 percent of GDP now. This has meant a sharp drop in the supply of new Treasury debt, a development likely to reduce yields.
In the year to April 2014, the total net issuance of US Treasuries was US$581 billion, down dramatically from just over US$1 trillion in the previous 12 months. Moreover, in the last 12 months Fed Treasury purchases totaled US$514 billion, meaning that the Fed bought almost 90 percent of net supply.
As tapering proceeds, the share of net supply taken up by the Fed will decrease. But with the budget deficit also shrinking the required extra purchases by the private sector may be relatively modest, preventing a sharp rise in yields.
International investors will help here. Foreign holdings of treasuries have increased by an average of US$455 billion per year in the last three years, enough to cover around 60 percent of the likely Treasury issuance for calendar 2014. With the Fed likely to buy around US$200 billion over the whole of 2014, the US private sector (actually a net seller last year) will only need to buy perhaps US$100 billion-200 billion, much lower than its average annual purchases from 2008-12.
The picture is mixed for equity prices. The main US equity indices have risen so far this year, despite tapering. Given that US equity prices correlated in recent years with changes in the size of the Fed balance sheet, this is perhaps surprising.
The picture is a bit more complicated than just looking a few key stock indices allows, however. In the US, some of the frothier stock indices have performed quite badly in recent months. And in some of the major emerging markets, stock markets have also performed poorly this year.
So in some of the riskier parts of the equity universe, there is weakness, and Fed tapering may have contributed to this. It remains unclear whether this weakness will spread to the main equity indices, although there are a few warning signs.
One cause for optimism regarding the impact of tapering on both the economy and on financial markets comes from monetary developments. Reduced Fed asset purchases mean reduced monetary injections and might be expected to see money supply growth slow – which would normally be bad for asset prices and economic activity.
Yet so far this year there is little sign of this happening. Narrow money (M1) grew by over 10 percent in the year to April, up from 7.9 percent in December 2013.
It appears that while money creation by the Fed is tapering off, money creation by the banking system has accelerated. The strong pace of overall lending growth is also occurring despite relative weakness in mortgage lending.
If this pattern continues then the risk of a sharp correction in financial markets due to tapering will be reduced. This in turn would be good news for US economic growth. There are some warning signs but so far 2014 yields some cause for cautious optimism.
Adam Slater is a senior economist at Oxford Economics and Gabriel Stein is director, Asset Management Services.
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