Financial markets have become concerned that greater fiscal stimulus - after the Democrats won the White House and the Senate - and a strong economic rebound induced by vaccines will spur the Federal Reserve to taper its bond buying prematurely in 2021 to the detriment of risk assets.
Source: Bank of Singapore, Bloomberg
Overnight, President-elect Biden said his first pandemic aid package would be USD1.9 trillion - higher than expectations even if the final figure Congress passes is likely to be closer to USD1.0 trillion - while Atlanta Fed President Bostic earlier this week said the central bank may start cutting its pace of quantitative easing (QE) from USD120 billion a month of bond buying this year.
The prospects of fresh fiscal stimulus and early Fed tapering in 2021 have caused US Treasury yields to jump sharply in January with 10Y yields rising from 0.91% to as high as 1.18% this month.
Source: Bank of Singapore, Bloomberg
We expect 10Y yields will reach 1.50% over the next one year but we don’t think the Fed will induce a further sharp sell-off in Treasury bonds by cutting its asset purchases suddenly this year. Instead the Fed is acutely aware of the 2013 ‘taper tantrum’ when financial markets reacted adversely to the central bank first announcing it would slow down its third and last round of quantitative easing (QE3) from the 2008 financial crisis.
As the first chart shows the Fed subsequently reduced the pace of its bond buying only gradually over a full 12 months.
Thus, overnight, Fed Chair Powell said in a Bloomberg interview: ‘We know we need to be very careful in communicating about asset purchases. Now is not the time to be talking about exit. I think that is another lesson of the global financial crisis, is be careful not to exit too early.’
Powell also said the economy is still ‘far from our goals’ on inflation and unemployment.
We expect the Fed will continue to support risk assets this year by not tapering its bond buying until 2022. We also expect the Fed will not start raising its fed funds interest rate from 0.00-0.25% until 2024 or 2025 as inflation remains below its 2% target as the second chart shows. Powell said it was ‘no time soon’ to consider raising interest rates.
Vice Chair Clarida told Bloomberg separately that ‘we’re not going to lift off until we get 2% inflation for a year.’
Thus, even if inflation hits 2% in 2021 as the US recovers, the Fed will only start hiking rates when inflation has exceeded its 2% goal long enough to average 2% for a full year. This is the Fed’s new dovish strategy of average inflation targeting.Disclaimer applicable to recommendation
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Version: July 2020