Why the True Taper Test Is Still to Come

The U.S. Federal Reserve began tapering its quantitative easing (QE) programs in December 2013 and since then, it has reduced the size of its combined monthly QE purchases from $85 billion to $45 billion.

Now that the Fed’s QE tapering is almost half done, you may be thinking that markets have adjusted well to the Fed’s reduction in the amount of new U.S. securities and treasuries it buys each month. But as I have written in past posts, the taper’s real market test has yet to happen. Today I’ll provide a more detailed explanation of why I maintain this view.  

Let’s start with a quick reminder of how the U.S. Fed’s current QE programs work.

The Fed began its third round of QE in September 2012, and of the $85 billion in debt it purchased each month, $40 billion was in mortgage-backed securities (MBS) and $45 billion was in newly issued U.S. treasuries. This was done with “new money” and while QE thus increased the money supply, more importantly, it reduced the supply of U.S. government-backed securities and treasuries that are available for investors to purchase each month. This soaking up of supply altered the natural supply/demand balance for U.S. debt and helped keep U.S. bond yields at microscopic levels as a result.

There was real fear that bond yields would rise sharply when the Fed began to reduce its monthly asset purchases, and for good reason. When U.S. Fed Chair Ben Bernanke first uttered the word taper in May of 2013, ten-year U.S. government bond yields surged from 1.76% that day to 2.16% by the end of that month, and continued to rise steadily throughout that summer, reaching 2.98% by Labour Day. The Fed coaxed fixed-income investors out of full-fledged panic mode with reassurances that its tapering plans would not be allowed to cause bond yields to surge higher, and calm was gradually restored.

Fast forward to today. The Fed has reduced its monthly purchases of U.S. treasuries and mortgage-backed securities by $10 billion for four straight meetings, taking its total monthly purchases from $85 billion down to $45 billion while ten-year U.S. bond yields have hovered in the 2.60% range, where they stand today. This evolution has been interpreted as a reassuring signal that U.S. bond yields can withstand the Fed’s QE withdrawal, but here is why I am not yet convinced.

The U.S. Federal government has been reducing the size of its budget deficit at the same time as the U.S. Fed has been tapering. According to David Rosenberg, over the first nine months of its current fiscal year, which runs from October 1 to September 30, the U.S. federal government has reduced its deficit to $436 billion, as compared to $626 billion in the prior year.

This means that the U.S. federal government has sharply decreased the amount it needs to borrow each month to fund its budget deficit at the same time as the Fed has reduced the amount of U.S. treasuries and securities it buys. So in real terms, the amount of newly issued U.S. government debt that is available to the market each month has been shrinking alongside the Fed’s tapering of QE.

Furthermore, the proportion of new debt that the Fed buys has remained the same. To wit, when QE was running at $85 billion/month the Fed was buying 53% of the newly issued supply, whereas since the start of the U.S. government’s 2014 fiscal year last October, the Fed has purchased 52% of the U.S. treasury’s new issuances.

Thus, since tapering began the market has not been asked to take on a greater supply of newly issued U.S. government debt each month, and even while the Fed has reduced the nominal amount of its purchases, the proportion of newly issued debt that it has bought remains virtually unchanged from where it was at the height of QE3.

In summary, all of the talk about tapering misses the main point. What matters most is the amount of debt that the market is being asked to absorb, and this is primarily determined by two factors: 1) the size of the US deficit, which impacts the overall supply of newly issued bonds, and 2) the amount of those bonds that the Fed is buying (QE), which determines the level of artificial demand that is acting against natural market forces.

So far, the reduction in QE has been roughly balanced by the reduction in the deficit. The true taper test will happen when the Fed’s withdrawal requires the bond market to actually buy more U.S. government bonds, and it is only then that we will see the real impact that the taper has on U.S. and global bond yields.

Five-year Government of Canada bond yields were flat last week, closing at 1.58% on Friday. Five-year fixed-rate mortgages are available in the 2.84% to 2.99% range and five-year fixed-rate pre-approvals are offered at rates as low as 2.99%.

Five-year variable-rate mortgages are available in the prime minus 0.65% range, which works out to 2.35% using today’s prime rate of 3.00%. Well-qualified borrowers who know where to look may even be able to do a little better than that.

The Bottom Line: The U.S. Fed taper has occurred at the same time the U.S. federal government has sharply reduced the size of its deficit. Thus, the fundamental question of how U.S. bond yields will respond when the U.S. treasury needs the broader market to purchase more of its debt has yet to be answered. As tapering continues this true test is not far off, and given the close correlation between U.S. and Canadian bond yields, its result will have significant implications for both our fixed and variable mortgage rates.