Skip to content

Investment Strategy Brief: Taper Time?

Investors worry that interest rates will rise if the Federal Reserve tapers asset purchases. History shows otherwise.

View PDF

The Federal Reserve won’t taper until it’s sure it can. As such, the tapering decision (whenever it comes) should simply be taken as further confirmation of a return to normal. We expect other forces to keep interest rates low and we remain constructive on risk-taking.

Previous tapers have led to falling not rising interest rates. As seen in Exhibit 1, the 10-year U.S. Treasury yield has a history of rising during periods of quantitative easing (QE) and falling during tapers (and beyond). This is opposite of what one might expect. What’s going on? In these past examples, investors feared the Fed’s (premature) tapering was putting the economy — and, by extension, the financial markets — at risk. The resulting “flight-to-safety” pushed interest rates down. We wouldn’t expect the same flight-to-safety response today as the economy seems to be on more stable footing. But, interestingly, any tapering now (when it comes) may still push interest rates lower — as less money printing may reduce investor inflation fears.

There is always someone ready to step in and buy. The knee-jerk reaction to any tapering announcement is that less bond purchases mean less bond demand. However, lost in that train of thought is how the broader market responds and who takes on the role of marginal buyer. The biggest candidate to step in and buy this time? Pensions. Thanks to a stock market that’s up dramatically and a state and local cash windfall from the Biden administration (some of which will make its way into pension funds), pension funding statuses have improved materially. Generally, a better funding status means a greater fixed income allocation — and a new home for those Treasuries (and mortgage-backed securities) the Fed no longer wants.

Policy coordination — and what it means for interest rates. Over the past several years — and especially during the worst of the pandemic — one could be forgiven for believing fiscal and monetary policy were joined at the hip. The respective policymakers may not be in “direct contact” but the smoke signals being sent both ways are clear enough. Far from meaningless speculation, this has practical implications. As the Biden administration’s two-part $4 trillion infrastructure bill is reduced in size through negotiation, the Fed may not feel the same need to provide its “unique” financing; tapering could end early, but the pool of available bonds to buy would also shrink. Regardless of the eventual size of the infrastructure bill, the amount of financing needed over the next year will pale in comparison to that spent over the last. Even the full $4 trillion in infrastructure bills would be a reduction from the past year’s $5 trillion-plus in pandemic relief. And while not all of that pandemic relief money was immediately spent, neither will the infrastructure appropriations — instead spent over eight years, and some of that likely tax-financed.

European monetary policy will remain supportive. On the back of an improvement in the growth and inflation outlook for Europe there has been increased speculation about a taper by the European Central Bank (ECB). This is very premature, and likely somewhat due to a misunderstanding regarding the ECB’s different purchase programs. The ECB’s Pandemic Emergency Purchase Program (PEPP) is €1.9 trillion in size and scheduled to end in March 2022. Changing the amount of weekly PEPP purchases without changing the program’s overall size is not a taper, even though commentators often think it is. A true taper would occur if the PEPP envelope is shrunk in size or if the size of the second purchase program, the Asset Purchase Program (APP), is reduced. The APP is open-ended and runs at €20 billion a month. We do not foresee any tapering by the ECB this year and, by extension, no pressure on the Fed coming from Europe. If anything, relatively low yields in Europe will continue to act as an anchor on U.S. rates.

Market implications: The taper timeline will not materially impact financial markets. We don’t place too much importance on when and how the Fed will taper, as we don’t believe it will materially impact the economy or financial market functioning — at least not broadly speaking. The Fed has been down this path before and should be able to exit its bond purchase program with minimal market disruption. Other investor demand will fill the void, as fundamentals (modest longer-term growth, transitory inflation) support still-low interest rates. There are many risks to watch for in the current market environment, but the Fed tapering isn’t one of them.

© 2021 Northern Trust Corporation. Head Office: 50 South La Salle Street, Chicago, Illinois 60603 U.S.A.

IMPORTANT INFORMATION. For Asia-Pacific markets, this information is directed to institutional, professional and wholesale clients or investors only and should not be relied upon by retail clients or investors. The information is not intended for distribution or use by any person in any jurisdiction where such distribution would be contrary to local law or regulation. Northern Trust and its affiliates may have positions in and may effect transactions in the markets, contracts and related investments different than described in this information. This information is obtained from sources believed to be reliable, and its accuracy and completeness are not guaranteed. Information does not constitute a recommendation of any investment strategy, is not intended as investment advice and does not take into account all the circumstances of each investor. Opinions and forecasts discussed are those of the author, do not necessarily reflect the views of Northern Trust and are subject to change without notice.

This report is provided for informational purposes only and is not intended to be, and should not be construed as, an offer, solicitation or recommendation with respect to any transaction and should not be treated as legal advice, investment advice or tax advice. Recipients should not rely upon this information as a substitute for obtaining specific legal or tax advice from their own professional legal or tax advisors. Information is subject to change based on market or other conditions.

Past performance is no guarantee of future results. Performance returns and the principal value of an investment will fluctuate. Performance returns contained herein are subject to revision by Northern Trust. Comparative indices shown are provided as an indication of the performance of a particular segment of the capital markets and/or alternative strategies in general. Index performance returns do not reflect any management fees, transaction costs or expenses. It is not possible to invest directly in any index. Gross performance returns contained herein include reinvestment of dividends and other earnings, transaction costs, and all fees and expenses other than investment management fees, unless indicated otherwise.

Northern Trust Asset Management is composed of Northern Trust Investments, Inc. Northern Trust Global Investments Limited, Northern Trust Fund Managers (Ireland) Limited, Northern Trust Global Investments Japan, K.K, NT Global Advisors Inc., 50 South Capital Advisors, LLC, Belvedere Advisors LLC and investment personnel of The Northern Trust Company of Hong Kong Limited and The Northern Trust Company.

Jim McDonald

Chief Investment Strategist
Jim McDonald is an executive vice president and the chief investment strategist for Northern Trust. He is responsible for overseeing the strategic and tactical asset allocation policy for our institutional and wealth management clients globally.