Divyang Shah, Senior IFR Strategist
Previous tightening cycles have been focused on a higher Fed Funds rate but the equity market tended to ignore this and instead focus on the underlying rationale for higher rates (usually stronger growth). But QE is very different in that any tapering of Treasury/MBS purchases is perceived to have a more significant impact on risk markets.
We would caution against an overly pessimistic assessment of the impact of the Fed taking its foot off the monetary accelerator. Firstly, tapering of QE and an eventual halt will happen in stages with the initial focus being on preventing the balance sheet from expanding.
Trying to keep the balance sheet from contracting will involve some Treasury/MBS purchases. It won’t be until the Fed starts to shrink its balance sheet that we can say that the Fed is tightening policy.
But even if the Fed is no longer doing QE and its balance sheet is contracting there is no automatic link between ending QE and higher interest rates.
Remember that unlike QE the Fed has set numerical thresholds for higher interest rates and based on these thresholds the Fed is still a long way away from higher rates.
Thus tapering from the Fed is unlikely to put an end to the rally that we have seen on equities/risk. Although there is a communication challenge for the Fed to overcome in comforting the markets that:
1) tapering QE means less accommodation and not tightening of policy, and
2) even if QE ends the bar for higher interest rates remains high.
Just as important as these messages is the impact of uncertainty as to how economic conditions will evolve. This uncertainty explains why the Fed injected the wording that the committee is “prepared to increase or reduce the pace of its purchases” to give it flexibility.
While FOMC members might agree on the need to remove current accommodation there remains a lot of uncertainty as to degree to which to remove the foot off the accelerator or even lightly tap on the brake (natural shrinking of balance sheet).
The nuances are likely to be expanded upon by the Fed and should help to prevent a sharp selloff on risk/equities as well as preventing bond yields from rising sharply.
Given that the Fed will attempt to divorce expectations of tapering/end to QE from expectations of the first rate hike the Treasury curve should steepen.
The 2s/10s Treasury curve could steepen all the way back to 280bp from its current level just under 170bp.
