Key Highlights
- Fed tapering expected to start in 4Q21
- Fed takes a more hawkish stance on inflation
- Rate hikes expected to be confined to the shorter end of the curve
Fed signals start of tapering
After nine months of speculation, the US Federal Reserve all but confirmed the framework of tapering in its September meeting, with Fed Chair Powell commenting that the conditions for tightening are all but met. Although the exact details have yet to be fleshed out, the broad overview/consensus was that it would likely start in December and conclude before H2 2022. This would imply a tapering pace of at least US$15 billion a month, likely split between US$10 billion for Treasuries and US$5 billion for Mortgage Backed Securities (MBS).
The announcement was consistent with higher projections across the forecast horizon, due in part to more persistent bottlenecks. It was also notable that Powell's comments on inflation leaned towards a hawkish stance relative to his Jackson Hole discussion. As a result, the dot plot was revised higher. Fed officials are now evenly split between raising rates and keeping rates on hold for 2022, while the median rate hike in 2023 and 2024 points to three.
Tapering expectations largely priced in
Inevitably, there was some upward pressure on yields following the announcement, fueled by a similarly hawkish turn in other G7 central banks. However, we do not think there is cause for worry as we assess that tapering has largely been priced in before this meeting. In 2013, when the Fed started to taper, bond yield fell instead of going higher as market participants unwound their short positions built up before. We do not expect anything different this time round.
In addition, after three months of declining/sideways bond yields and real money accounts waiting on the sidelines for better entry levels, we expect any potential upward movements in yields to be eagerly gobbled up. This can also serve as compensation for demand after tapering in the months ahead.
Higher yield levels look attractive
The long end remains attractive to us on any uptick in yields. Notably, we observe that the long end has been relatively subdued compared to the belly of the curve, and curve steepening has not been observed. It appears that market participants are pricing in shorter end rate hikes at the expense of the long end.
In other words, market participants believe that tightening at the shorter end will be successful in curbing inflationary fears, which means that there is less need to tighten further out. This is a direct consequence of the new regime of average inflation targeting, and we would be willing buyers at higher yield levels. The house view is for the 10-year yields range through to the end of the year to remain at 1.20% - 1.60% and we remain neutral at current levels.
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