Tapering isn’t lift-off
As the global economic recovery widens, attention is clearly turning to when and how central banks will begin to reduce the bond-buying programmes introduced to bolster economies at the height of the pandemic crisis. The timing of so-called ‘tapering’ has become something of an obsession among many market commentators who seem to simply perceive ‘tapering’ to mean ‘tightening’.
In managing a global, unconstrained bond fund, weighing sentiment or expectations versus the fundamental backdrop is key. If we think the former is driving price action more than the latter, we can be on the lookout for attractive opportunities to take some contrarian positioning.
The benefit of a flexible, active approach is that we can choose where to be more tactical and how to balance the risks. For example, for much of the past 6 months we have been structurally long duration even when owning duration looked ‘expensive’ versus market expectations of where yields should go next. Our assessment has been that, with a rate rise unlikely to be imminent, yields could still go lower, or at least not meaningfully higher. However, we have been able to use our strategy’s flexibility to tactically play the curve when more attractive buying opportunities present - as was the case in September when we reduced duration as yields rose.
The lady isn’t tapering
In an era where central bank decisions have become largely about optics, European Central Bank President Christine Lagarde chose her words carefully when she said “The lady isn’t tapering” at a news conference following the ECB decision last month to slow the pace of asset buying under its pandemic emergency program. That didn’t stop plenty of people interpreting the action as a taper in all but name. Are they right? Does it matter?
Firstly, it’s important to note that the ECB’s decision relates to its pandemic emergency purchase programme (PEPP). Lagarde said that the ECB is only recalibrating the PEPP by moderately lowering the pace of net asset purchases and that those purchases will continue until at least the end of March 2022. Meanwhile, an older programme of quantitative easing – the Asset Purchase Programme (APP) – which pre-dates COVID-19, will continue at the current pace of roughly €20 billion per month. Indeed, there is some speculation that the tapering of the PEPP may be accompanied by a boost in purchases under the APP.
The ECB expects the APP to continue for as long as necessary and to end just before it starts raising interest rates. This is key because it appears to signal that while the ‘non-taper’ of the PEPP may appear hawkish optically, it is not linked to raising rates. In short, a reduction in bond purchases through PEPP doesn’t signal any meaningful end to bond buying as a whole for the ECB, and certainly doesn’t signal raising interest rates.
Two different tools of monetary policy
US Federal Reserve Chairman Jerome Powell has equally been at massive pains to point out that tapering is very different to raising interest rates.
Most of the world’s central banks use two main monetary policy tools: setting short-term interest rates and buying bonds through quantitative easing. The market seems to perceive that tapering the latter always directly precedes meaningful change to policy regarding the former. In a speech this August, Powell was keen to stress this is not the case, stating:
“ The timing and pace of the coming reduction in asset purchases will not be intended to carry a direct signal regarding the timing of interest rate lift-off, for which we have articulated a different and substantially more stringent test.”
Powell wants the market to understand that the threshold for rate rises is much higher than for tapering. In order to raise rates, the Fed will need to see substantial and sustained recovery in economic data. Economic recovery may be broadly going well but not without a great deal of uncertainty still around the unpredictability of Covid-19, supply chain disruption, labour supply shortages, etc.
Meanwhile, the current hot debate around exactly how transitory inflation will be is a fine balancing act for central banks. For now, the Fed is happy to let inflation temporarily run a little hotter to make up for past low inflation by adopting average inflation targeting rather than a 2 percent ceiling.
Nonetheless, we have seen yields move higher recently in response to what was perceived to be a more hawkish ‘dot plot’ from the US Federal Reserve in September. In these situations where market expectations are the key driver, it is important to assess what is and isn’t priced-in when assessing the likely direction of travel.
How it’s different to 2013
Getting back to the market reacting to optics rather than action, let’s remember how the notorious ‘taper tantrum’ of 2013 played out. Then-Fed Chair Ben Bernanke announced tapering of bond purchases in May of 2013, triggering a dramatic spike in yields and declines across most other global asset classes, too. However, all this price action took place before tapering actually began seven months later, when the market barely seemed to notice. Furthermore, the first rate-hike was not announced until two years later, in December 2015. This demonstrates how tapering can be a long and winding process – and quite separate to rate hikes.
This time, so far at least, there have been no tantrums since the Fed announced its expectation to begin tapering towards the end of this year or early next. It seems that the Fed has learnt from 2013 in the way it signals its intention to taper. Powell has been quite cautious to get the tapering conversation happening well before it actually occurs, to make sure the market is comfortable with it.
Rational reasons to hold government bonds
As talk of tapering seems likely to dominate market thinking for the rest of the year and beyond, we might have spikes in yield and some volatility but, in general, we believe there are positive, rational reasons to hold government bonds in an unconstrained fixed income portfolio, not least the attractive liquidity and diversification they provide. While many people seem to think yields can’t go much lower with the economic backdrop improving, our view is that there are a number of powerful ‘bond-positive’ elements in play.
Policy globally remains accommodative and the presence of a lot of price-insensitive buyers such as central banks and insurance companies means there are still more bond-buyers than bond-sellers in the market. As such, we believe the risk/reward outlook is actually skewed towards lower, not higher, yields. We wouldn’t ‘rule out’ duration just because many spot forecasts are for higher yields. Each time yields rise we expect more buyers to come in at those cheaper levels. So, it’s key to be tactical and flexible but overall we see a powerful positive dynamic for duration that many would probably disagree with.