Should you fear the taper?

Sep 22, 2021

Tan Chu Ren

CENTRAL banks have been talking about tightening monetary policy, starting with tapering the amount of bond purchases they make each month. The Bank of Canada and the Reserve Bank of Australia have already started tapering and the US Federal Reserve has started discussing it.

However, some investors may still remember the taper tantrum of 2013 and others might have at least heard about it. Ben Bernanke, the Fed chairman at that time, suddenly revealed that the Fed was thinking about tapering during his May 22, 2013 congressional appearance. But just how badly did the financial markets react?

From the accompanying table, the damage done to financial markets does not look that bad. However, an increase of 47 basis points for 10-year US Treasuries ("UST") was still quite impactful. On further hindsight analysis, the S&P 500 index still managed to appreciate 29.6 per cent one year from the 2013 bottom, despite the volatility following Mr Bernanke's congressional appearance.

Moving on, in the 2013 December meeting, the Fed announced it would start reducing its bond purchases in 2014. The 10-year UST yields hit a high of 3.03 per cent at the end of 2013 which was not exceeded for a period of nearly five years until the Fed started quantitative tightening in October 2017.

US stocks also performed quite well. In 2014 while the Fed was tapering, the S&P 500 index returned 11.4 per cent for the year. S&P 500 investors would have gained 27.6 per cent during the three years after the Fed ended its asset purchase programme in October 2014. When the Fed announced quantitative tightening in September 2017, the index gained 15.7 per cent over the following year.

To surmise, tapering or quantitative tightening is not quite the "Big Bad" that investors should fear. Furthermore, Fed chairman Jerome Powell seems to be preparing market participants quite well for the eventuality of tapering.

Communication is every bit as important as actual monetary policy decisions for investors. There are various studies that show that central bank communication is a key determinant of the market's ability to anticipate monetary policy decisions and the future path of interest rates.

To hammer home the point, we can examine the events in 2020 too. When bond prices were falling in March last year, the Fed announced it would purchase Treasury and agency mortgage-backed securities "to support smooth market functioning", essentially suggesting infinite quantitative easing.

It also established two credit facilities to buy corporate bonds to support the bond market. The bond market shortly rebounded despite the Fed only making purchases in mid-May and at its peak, held US$46 billion in corporate bonds while dedicating an initial US$75 billion equity investment and a maximum size of US$750 billion for the two credit facilities.

Thus, while most market participants will discuss tapering asset purchases, chances are the impact on financial markets will not be that big, or lasting.

The Fed would have learnt a lesson on how not to do it and chairman Powell is also trying hard to differentiate tapering and interest rate policies. The latter suggests that the Fed still wishes to continue accommodative monetary policy while weaning off some support. Thus, based on the data and this logic, investors should stay invested or continue investing even if blips in the market occur.

However, despite the low risk of a taper tantrum, investors should still look out for other events that can disturb financial markets. On Thursday (Sept 23), the US Fed will release its monetary policy statement and Mr Powell should announce tapering plans. Additionally, it is also the coupon payment date for the EVERRE 8.250% 23Mar2022 Corp (USD) bonds and this event may garner more market attention over the other.

EVERRE 8.250% 23 Mar2022 Corp (USD) are bonds issued by China Evergrande Group. While it is widely expected that China Evergrande Group will default on its coupon payments, it is much harder to know what to expect from the consequences due to its huge liabilities and wide network of affected companies as well as investors. The immediate effects will be and are already taking place within the Chinese real estate and financial sectors.

China GDP growth will most probably be slowed, and being the second-largest importer in the world, global economic growth will likely be affected too, especially emerging markets that have strong links to the country.

As such, in the short term, I will closely monitor the emerging markets and Chinese equities for any attractive opportunities that may pop up. Emerging markets still have strong growth potential and these are some of the best times to accumulate investments for the long run.

When China Huarong Asset Management ran into trouble, the Chinese government took some time to bail them out. If they decide to do so again, it may take some time for them to announce measures, whether supportive or not. As such, there is no rush to buy the dip on these distressed bonds. Perhaps a more opportune time will be when the Chinese government announces their intentions for China Evergrande Group, if at all.

Individual bond investors can keep an eye out for higher-rated Chinese real estate bonds such as COGARD 6.500% 08Apr2024 Corp (USD) and SHIMAO 6.125% 21Feb2024 Corp (USD). Their prices have dipped slightly and investors can potentially improve their total returns by adding them to their portfolios. However, their prices may fluctuate even more on Thursday, depending on how events play out.

Due to the large uncertainty surrounding China Evergrande and the heightened market volatility, investors will do well to stay nimble and watch for opportunities in the spaces mentioned.

The writer is the Fixed Income Analyst of the Bondsupermart Team at iFAST Financial Pte Ltd (IFPL), the Singapore subsidiary of SGX Mainboard-listed iFAST Corporation Ltd.