A cute chart that has been going around is this idea that QE caused rates to INCREASE.  Therefore, tapering should cause rates to DECREASE.  <crickets>  As absurd as this sounded, I had to whip out the chart to take a look.

Sure enough, after QE (and Operation Twist, denoted as “OT”), rates did increase soon thereafter.  But that would be an oversimplification.  To me, the main takeaway from the chart is that the markets are forward-looking and anticipatory – sometimes overly so.

  • QE1 and the Taper Tantrum were two events that may have caught the markets off-guard. That is why we got a “true” reaction afterwards.
  • For all the other events (QE2, Operation Twist, QE3, Tapering), the markets started pricing in the event many months before. So much so that after the event, we had a strong reverse reaction.
  • Note that in most cases, the average level of rates (say 1 year) after the QE was lower than the 1 year before QE. If it wasn’t for the Taper Tantrum, I would have expected that rates would have remained low after QE3.  I mean rates before QE1 were around 4% and below 2% after QE3.  I fail to see how one could argue that QE caused rates to rise overall, when rates fell 200 basis points over this period.  Granted, there were other things going on in the world so QE was not the only factor affecting rates.  But c’mon.  To claim that QE caused rates to rise because the markets overpriced it before the event and rebalanced afterwards is just wrong.

This is not much different from say, a payroll where the “consensus” is 200K jobs, it comes in 225K and the markets rally.  If the markets have a 250K whisper and don’t get it, the markets will rally.  You can not argue that higher payrolls are bad for rates.  Similarly, when central bank action is anticipated, the markets will price it in well in advance.  The market reaction to an event all depends on what is priced in going in. 

  • Before QE1, there was not much priced in because this was a fairly new idea, and this may have been a bit of a surprise. So we had an outsized reaction.  Once the markets acclimated, rates went higher, but were on average lower than previous levels.
  • Now that the markets knew what to expect from the Fed, a combination of weaker data and anticipation of the QE2 caused rates to go lower. Bulls wanted to go in for the ride, and bears wanted to stay away.  Once QE2 was announced, bulls took profit and bears felt free to put on new positions they had been avoiding because of a new round of QE.
  • QE2 did not move the markets as much as QE1, so the Fed engaged in Operation Twist. Again, the markets anticipated a move and the bulls piled in beforehand and the bears stayed away.  Once it was announced, the bulls took profit and the bears put on new trades.
  • QE3 was a similar story. The effect was more muted however.  Part of this could be that the marginal effectiveness of QE declined.
  • The large spike in rates 8 months after the start of QE3 was the Taper Tantrum. And we see again, that we had an outsized anticipatory move ahead of the actual Taper, and once Taper occurred, rates came back down because the bears took profit and the bulls were free to put on new trades.

The lesson here is that the markets are highly anticipatory and will price in an event before it happens.  What is perplexing in the case of the upcoming portfolio reinvestment tapering is that currently, the potential rate increase from a tapering does not “appear” to be priced in.  The million dollar question is, is it already currently priced in (somewhat)?  But we just can’t see it?  In other words, would the ten year yield be 25+bps lower if tapering was not on the horizon?  And the tapering is keeping rates from being lower?  This is not clear.  I tend to think we should get some kind of selloff going into the taper, but maybe Trumpidity is trumping that?

It’s also possible that because the taper is going to be phased in over 1+ years, the markets do not think this will have that much of an impact.  I think the taper (and resulting decrease in the balance sheet) will have a large eventual impact, but it may take a little time for the algos and bullish buyers of dips to realize what a tailwind they had been trading with all this time.

Right now, the positioning indicators like the COT and JPM client survey aren’t showing much positioning going into the taper.  That in itself could make this unlike most of the other recent Fed balance sheet actions.  Part of this could be versions of the above chart making the rounds.  In the past, we would have been short going into the taper announcement.  But could the bears be waiting on the sidelines for a dip in rates post-announcement to sell (as implied by the Chart)?  If you believed the chart and thought rates could dip post-announcement, why would you be short going in?

To summarize, this taper has been well-telegraphed.  I think that in the past, the markets had been very anticipatory of a Fed move, and so we got the move before a new Fed action and the opposite move after the Fed action.  This time around, there does not seem to be any pre-event positioning.  So I would expect us to get a muted move (assuming we don’t get a large last-minute move).  The taper is unequivocally bad for fixed income in the long run – there would be one less major buyer of fixed income.  The big question is, what is priced going in?  Are people short or long going in?  Are people expecting rates to fall after the announcement because of the above chart?  Let’s evaluate this as we get closer to the September meeting, where the taper announcement is almost a sure thing.  For now, having moderate position sizing going into the taper and leaving room to add makes the most sense.