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Brian Levitt | August 19, 2021

Can we get through tapering without a tantrum?

Are the markets headed for “Taper Tantrum: Part Two”? Not necessarily. Brian Levitt details some important differences between 2021 and 2013 that may help.

I haven’t heard this much talk about tantrums since I had toddlers running around my house. Fortunately, I’ve graduated from having children who cry, wail, and throw themselves on the ground for little discernable reason — but now I find myself in a business cycle that is still young and potentially prone to outbursts. I find myself asking the same questions now as I did back in my earlier parenting days: “Are tantrums inevitable? Or can they be avoided?”

Remembering the 2013 ‘Taper Tantrum’

To keep the analogy going, in the last business cycle (2009-2019), the infamous “Taper Tantrum” occurred as the U.S. Federal Reserve (Fed) began to fuss less over the economy despite the market’s concerns that the economy wasn’t yet ready for the Fed to take away the pacifier. The market staged its own version of a public meltdown: U.S. interest rates spiked, credit spreads widened, equities sold off, and all things emerging markets plummeted.1

Today, as the Fed foreshadows the possibility of dialing back its support for an expanding economy, those who remember the last tantrum are wondering if we’re headed for another.

The calm before the storm?

The worst part about tantrums, as all parents can attest, is that you never know when they are coming. There’s a lot of speculation that another tantrum may be on the horizon. The markets had appeared to be relatively sanguine over the possibility of the Fed beginning to scale down its asset purchases. Even this week’s CNBC headline, “There’s Growing Support Within the Fed to Announce the Tapering of Bond Purchases in September,” didn’t send the markets into hysterics. U.S. equities, as represented by the S&P 500 Index, closed Monday at an all-time high.2

By Wednesday, the S&P 500 Index had fallen by 1.7% from its high.3  Had this been just the proverbial calm before the storm? That moment when you’re enjoying your sweet, lovable toddler right before they start hitting, kicking, and ignoring rules?   Not necessarily. Sometimes it’s just easier with the second child — er, business cycle. For one, we learn a thing or two along the way about preventing tantrums. As a first-time parent, my methods for trying to resolve a situation (“stop it,” “you’re fine,” “get over it”) would only exacerbate things. By the second time around, I had learned that simply affirming what the child is feeling (“you’re mad,” “I know that hurts,” “I’m sad for you”) is a far-better, almost magical, approach.

The Fed adjusts its communication style

Similarly, the U.S. Federal Reserve also appears to have altered its approach. In May 2013, then-Chairman Ben Bernanke surprised the market by saying that the Fed could “step down” the pace of asset purchases “in the next few meetings.” While there was no suggestion of a change in interest rate policy, the market nonetheless repriced its expectation for the future path of short-term interest rates 1% to 4% by mid-2015.4 It was like a parent telling a child that it’s time to leave the playground with no advance warning — that tends not to go over very well. This time, the Fed appears to have learned its lesson. We joke that the Fed, instead of announcing the tapering of asset purchases, has been “talking about, talking about tapering asset purchases.” The Fed appears to be moving gingerly so as not to scare the markets and tighten financial conditions, and thereby choke off the recovery. Thus far the market is pricing in only a very gradual rise in the federal funds rate over the next two years.5 Language matters in dealing with children and markets.

Today’s cycle isn’t like the last one

Second, sometimes you just get lucky with the fundamental construct of the child or business cycle. My second daughter was less prone to tantrum. It’s just the way she was built. In my view, the same can likely be said about this cycle:

  1. This time, inflation expectations are modestly elevated. In 2013, the world was still awash in the disinflationary impulses that had emerged in the aftermath of the financial crisis. The Fed was struggling to maintain inflation expectations (represented by the 2-year U.S. Treasury breakeven) at the 2% target.6 The Fed’s proposed adjustment to its balance sheets in 2013 appeared to be in response to the Fed’s anticipation of future inflation, rather than in response to realized inflation or the market’s expectations for inflation.

    Conversely, the Consumer Price Index is currently well above the pre-COVID peak7 and inflation expectations are above the Fed’s 2% target.8 As a result, it is less likely now than it was in 2013 that an indication of tighter policy would be viewed as the policy mistake that would send the U.S. dollar higher and risk assets lower.

  2. Many of the “fragile” emerging market countries aren’t as fragile as they once were. In 2013, the emerging market countries suffered significant capital flight as the Fed indicated its intent to taper asset purchases. At the time, many emerging market countries were running high current account deficits as their imports were far exceeding their exports.9 These countries had strong dependence on foreign inflows to finance consumption. As a result, they had acute vulnerability to currency fluctuations, resulting from their large volumes of foreign-currency debt.

    The current account picture is much different as these countries, like the U.S., have been consuming less and saving more. Moreover, the flow of capital into emerging markets over the past years is nowhere near as large as it was in the years prior to 2013.

    With external financing needs much lower and likely to remain suppressed as the pandemic continues to weigh on EM-domestic demand, I believe it is unlikely that EM assets will experience anything like the taper tantrum of 2013.

Conclusion

Just like all kids are different, so too are all cycles. Do we have to deal with another tantrum? I suppose it’s possible. Market volatility tends to occur with changes in policy. Again, you just never know with children or business cycles in the early stages of development. More importantly, I would view any type of outburst as developmentally appropriate and just a rite of passage along the way to this cycle maturing into a more stable one.

1 Source: Bloomberg, L.P. Interest rates represented by the 10-year US Treasury Rate. Credit spreads represented by the Bloomberg Barclays US Corporate High Yield Option Adjusted Spread. Equities represented by the S&P 500 Index. All things emerging markets is represented by the MSCI EM Index and the JP Morgan Emerging Markets Bond Index.

2 Source: Bloomberg, L.P. as of Aug. 16, 2021

3 Source: Bloomberg, L.P., as of Aug. 18, 2021

4 Source: Bloomberg, L.P. Based on 30-day Fed funds futures

5 Source: Bloomberg, L.P. Based on 30-day Fed funds futures

6 Source: Bloomberg, L.P., as of July 31, 2021.

7 Source: US Bureau of Labor Statistics, as of July 31, 2021

8 Source: Bloomberg, L.P., as of July 31, 2021

9 Source: International Monetary Fund, as of June 30, 2021

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The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

Tapering is the gradual winding down of central bank activities that aimed to reverse poor economic conditions.

Credit spread is the difference in yield between bonds of similar maturity but with different credit quality.

Fed funds futures are financial contracts that represent the market’s opinion of where the federal funds rate will be at a specified point in the future. The federal funds rate is the rate at which banks lend balances to each other overnight.

Breakeven inflation is represented by the difference between the nominal yield on the 10-year U.S. Treasury and the real yield (fixed spread) on the inflation-linked investment of the same maturity.

The MSCI Emerging Markets Index captures large- and mid-cap representation across 26 Emerging Markets (EM) countries. With 1,198 constituents, the index covers approximately 85% of the free-float-adjusted market capitalization in each country.

The Bloomberg Barclays US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody's, Fitch and S&P is Ba1/BB+/BB+ or below. The option-adjusted spread (OAS) measures the difference in yield between a bond with an embedded option, such as callables, with the yield on Treasuries.

The JP Morgan Emerging Markets Bond Index (EMBI) measures the total return performance of international government and corporate bonds issued by emerging market countries that meet specific liquidity and structural requirements.

The opinions referenced above are those of the author as of Aug. 18, 2021. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.