With markets currently alive to any twitch from the US Federal Reserve, the Fed’s announcement on Wednesday that it plans to sell just under $14bn of bonds and ETFs it acquired at the height of the COVID-19 crisis was always likely to spark some excitement, or perhaps a touch of trepidation, among market commentators.
The Fed’s messaging around monetary policy – that any inflation stemming from the US economic recovery should be transitory and lifting interest rates is far from policymakers’ minds – has been extremely consistent for the last year, and it has remained so throughout 2021 even as several data prints have suggested a more permanent form of inflation may be taking hold.
When it comes to tapering, however, we have seen a shift in the language being used by various Fed members in recent days. Fed vice chairs Richard Clarida and Randal Quarles recently stated that a discussion on trimming the central bank’s $120bn-a-month purchases of Treasuries and MBS could begin at “upcoming meetings”, adding to similar comments from San Francisco Fed president Mary Daly, Dallas Fed President Robert Kaplan and Philadelphia Fed President Patrick Harker. If the Fed chair, Jerome Powell, in mid-2020 famously said the Fed wasn’t even “thinking about thinking about” raising rates, then today he and his fellow FOMC members are clearly thinking about thinking about tapering.
The question for investors now of course is exactly when and how hard the Fed will tap on the brakes. Given the demonstrable recent strength of US economic data, including a healthy (though slightly below expectations) non-farm payrolls print of 559k on Friday, ahead of the policy meeting on June 15-16 it is worth considering just what the Fed is trying to signal by winding down its corporate bond holdings at this stage.
On the face of it, this move to unwind the Secondary Market Corporate Credit Facility (SMCCF) could be interpreted as the Fed signalling the inevitable; a first step to establishing a comfort level for further debate and perhaps a cue for investors to expect more than just lip service to the topic at upcoming meetings. The June meeting should be too early for us to obtain much more clarity but any discussion should set the tone for future expectations, with the September meeting perhaps a more reasonable goal for a clearer timetable once the dog days of summer are behind us.
The signal is more important than the noise here because the amount of corporate bonds and ETFs held in the SMCCF is a drop in the bucket. Having earmarked $250bn for the program in March 2020, the Fed currently holds $4.94bn in short-dated bonds ($4.8bn investment grade and $144.5m in high yield) and $8.6bn in ETFs ($7.4bn IG and $1.2bn HY). To put those values in perspective, US IG corporate issuance stands at around $720bn year-to-date and HY at around $257bn, equivalent to around $7bn of IG and $2.5bn of HY issued daily. The Fed’s holdings are also dwarfed by daily corporate bond trading volumes, so despite the central bank’s pledge to “minimize the potential for any adverse impact on market functioning by taking into account daily liquidity and trading conditions”, we don’t see it running into any problems.
The market opened flat to slightly softer on Thursday after Wednesday’s announcement but, after the initial surprise, it barely registered in secondary spreads. Importantly, both the US IG and US HY indices are very close to their all-time tights, and the continuing search for yield will very likely allow the marketplace to easily absorb this supply, particularly as the Fed described its timeline as “gradual and orderly”. While we don’t expect any material spread widening in the near term, we remain extremely wary of higher duration bonds given our view that the potential persistent inflation suggested by recent data isn’t priced into US Treasury yields, which currently sit around 1.58% at the 10-year point.
What we do expect is some specific dialogue on tapering at next week’s Fed meeting, which along with the meeting’s minutes released on July 7 should give us a better idea of the spread of views on the tapering timeline within the FOMC. While we don’t anticipate any change in policy in the short term, we sense the Fed has opened the door with its SMCCF announcement and we will be watching very closely for any discernible change in language next week.