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Federal Reserve moves towards November Taper

The Federal Reserve is very likely heading for a tapering of its bond purchases in November, but the longer-term outlook depends on how transitory the current bout of inflation is. If we are correct, i.e. it will fade more quickly than expected, then we should see the expectation of rate hikes delayed, supporting a further upward move in North American equities.

Federal Reserve decision

The Federal Reserve signaled this week that it would most likely be tapering its bond purchases in November provided it had a decent labor market print and if conditions were almost met (defined as substantial progress on its inflation and growth mandates). Faced with elevated break-even inflation for the next few years, the Fed increased its own inflation forecast, leaving the odds of a rate hike next year in the dot plots. What was interesting is the relatively subdued pace of forecasted interest rate increases from 2023 on. It suggests that the Fed believes long-term deflationary forces will come to the fore. This communication exercise is designed to keep the front end of the US Treasury curve well-contained to give time for the economy to grow. What we suspect will happen is that the Fed will be too slow to tackle the elevated degree of leverage in the system, leading to a correction in the resulting asset bubble in circa H2 2022.

Dynamics of growth and inflation

The Federal Reserve is tapering at a time of a deceleration of the US economy, leading to calls of stagflation - namely elevated inflation and stagnant growth. Indeed, even the Fed is becoming less convinced that inflationary pressures will ebb quickly while inflation expectations in the market are elevated for the next few years. The problem the Fed is faced with is that there are a plethora of shocks of various intensities that are destabilizing households’ expectations of a stable inflation. The Fed can contain some of these pressures by tapering and simply gaining time by taking back control of the narrative, but there is also a long term supply chain issue where the Fed has little control. However, we are already getting testimonies that hiring for warehouses is becoming easier now that Federal supplementary unemployment payments have disappeared.

Impact for the markets

Even though this Fed tapering is not completely what the market expected, it settles the question as to how the market would react in the short-term namely somewhat higher long-term yields. Its long term effect is harder to predict though. Liquidity being retrieved all along the US Treasury curve by the Fed should easily meet liquidity sloshing around in cash, both in the United States and abroad in a world starved for safe assets that generate yield. One unexpected consequence of tapering is likely that over time the US bond market is going to compete against the EM bond market – which had been one of the key fears of tapering as yields in the US become more attractive.

What does it mean?

The Fed didn’t fully deliver what the market expected leading to somewhat higher US Treasury yields, but the fear of tapering is fading and with it fears of a broader economic slowdown led by China, hobbled by a budding real estate crisis. That leaves equities in advanced economies to likely outperform in the coming weeks against a wall of worries as is typical of an advanced carry trade.

Sébastien Galy , September 27

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