The market impact of the Fed’s taper will be moderated by a significant decline in Treasury and Agency MBS issuance. An imminent taper is very likely now that a press trial balloon has been floated right before blackout and even the ECB is tapering. At the same time, Treasury is expected to lower coupon issuance and Agency MBS production is expected to continue to slow. In light of this, tapering can be thought of as maintaining the level of QE accommodation amidst significant declining issuance. While the mechanical impacts of taper will be blunted, the Fed’s taper announcement will still tighten financial conditions by bringing forward rate hike expectations. The Fed hopes to avoid another taper tantrum by separating taper from lift-off, but that is hard when one necessarily precedes the other. In this post we show how declining Treasury and MBS issuance will off-set Fed tapering and review the Fed’s communications challenge.
Treasury Is Massively Overfunded
The Treasury is on track to issue $2.5t in net debt next year, even though its forecasted borrowing needs over the period are only $1.5t. That is an extra $1t in issuance that doesn’t have to happen – and coincidentally around the same amount of Treasuries the Fed is buying each year. Recall, Treasury massively scaled up coupon issuance to record levels last year to finance pandemic related fiscal stimulus. The Fed did its part in the effort by purchasing $80b a month of Treasuries, but if coupon issuance is declining then that level of support is also no longer needed.
Treasury has already slightly cut its estimated fourth quarter issuance and commissioned a study on how to further adjust issuance. The baseline proposal from the study is a gradual 35% cut in coupon issuance, which translates to around a $1t cut in issuance for next year. Treasury will be reducing issuance just as the Fed is tapering QE purchases. It’s not clear exactly how either taper or issuance cuts will be implemented (it will have curve shape implications), but overall they will roughly cancel each other out (Note: Fed only buys off-the-runs that are not trading special, so lower auction issuance is not exactly the same). From the private sector standpoint, the flow of net issuance will be roughly unchanged so the stock of private sector Treasury holdings will continue to grow at around the same pace. The Fed will just own a smaller share of the overall stock.
The Refi Wave is Over
MBS production surged in 2020 as historically low mortgage rates prompted a wave of refinancing and new home purchases. Monthly Agency MBS issuance almost doubled from around $180b a month in 2019 to over $300b a month for most of 2020. Agency MBS outstanding reached $8.7t at the end of Q1 2021, a $1t increase over the past year. The Fed helped the market absorb the torrent of issuance by purchasing $40b a month, but that level of accommodation is no longer necessary as monthly issuance is gradually declining towards pre-pandemic levels.
Mortgage loan production has slowed significantly as high home prices discourage new buyers and fewer high rate mortgages are left to refinance. The data suggests that issuance remains robust but about $50 billion off the historically high levels seen in 2020. Tapering the current $40b a month in Agency MBS purchases would in large part be off-set by declining issuance, leaving the overall issuance to be absorbed by the private sector little changed from its current pace.
Lift-Off is Far Away
The primary impact of tapering comes from mechanically bringing forward the timing of a rate hike. The Fed’s playbook is to first taper, then raise rates, and then maybe shrink the balance sheet. Regardless of what the Fed says, taper implies we are closer to “lift-off.” The 2013 Taper Tantrum occurred in part because the market both pulled forward the timeline of lift-off and priced in a relatively aggressively rate hike cycle. That immediately disrupted markets and led to pull backs in rate sensitive trades, such as emerging market carry trades. This time around the Fed is eager to avoid another tantrum.
Powell has repeatedly separated tapering from lift-off by setting a much higher standard for lift-off. He wants the market to understand that though lift-off is closer, it is still far away. This is not easy because many market participants will simply perceive tapering as tightening. The tapering announcement will include language that aggressively dampens expectations for lift-off, and probably suggests a gentle hike cycle. The very high level of debt in the financial system magnifies the impact of changes in interest rates, so even small hikes would lead to significant volatility. A well communicated taper should not be disruptive to the market.
Neutral on Net
The impact of a QE program must be evaluated relative to expected issuance volumes. The impact of a $10b per month QE program is very different when net issuance is $5b a month than when net issuance is $500b a month. In the same way, tapering purchases amidst a significant decline in issuance may not have a meaningful market impact. In fact, maintaining the current QE program even as issuance declines would effectively be increasing monetary accommodation. That would not be prudent policy when inflation is high and growth is recovering.