Markets remain agog with the possibility of the Fed announcing the much maligned ‘taper’ as early as this December.
Consider this: On Monday the ISM Manufacturing Index for November came in at 57.3 instead of the consensus estimate of 55.1. Thursday, annualized GDP growth for the third quarter printed at 3.6%, handily beating analysts’ forecasts of 3.1%. This morning, Non-Farm Payroll data for November showed 203K jobs added against consensus of 185K, while the unemployment rate reported at 7.0% instead of 7.2%. Encouraging economic data that shows the Fed’s massive Quantitative Easing exercise to restore the economy may be nudging it towards a full-blown recovery.
It also raises the question on when Fed head Ben Bernanke will finally bite the bullet and ease back on the QE throttle as he promised earlier this year.
Markets are probably obsessing with a repeat of the global turmoil that occurred when the first hint of tapering was released in May this year.
But the market’s excessive speculation on the taper’s timing, and scale, may be misplaced, according to a Citi Research Credit Strategy study by analysts Stephen Antczak, Jung Lee and Municipal Strategy analyst George Friedlander.
Markets may have already discounted taper
The Citi analysts raise the possibility that the fact of the taper, and its likely impact, may have already been priced in by the markets considering that it has been heavily in the news since its announcement in May.
The Citi analysts also studied specific periods in the last 30 years when yields on the 10-year Treasury bond rose by 1% or more, with the corresponding changes in spreads on HG and HY paper.
Historically, spreads tightened whenever yields rose, but after this year’s taper threat in May, they broke from that norm.
“We saw the exact opposite happen this spring, with widening of 18 bp and 78 bp in high-grade and high-yield, respectively (see table below). Perhaps the difference between what normally happens and what happened this spring — 80 bp in high-grade and 280 bp in high-yield — was the pricing in of tapering,” say Citi.
The demand and supply equation
In another viewpoint that, in the words of Citi, “challenges the consensus,” markets may be failing to look at the aggregate demand and supply of paper when the Fed finally applies the brakes on QE.
“Even if tapering occurs next March the amount of Treasury bonds needed to be absorbed by the market (net supply less Fed purchases) will be at the lowest level in the post-Lehman era,” says the report.
It is clear therefore that the Fed’s reduced purchases (demand) will come about in a market that is already shrunk, and the chances of a major demand-supply imbalance are therefore dim. “With or without QE, there is a lot of cash looking for a home and fewer places to put it,” say the analysts, implying that a runaway rise in yields is unlikely.
However, the analysts warn that taper risk cannot be brushed aside completely, and could creep into the credit markets as a corollary from tremors in other assets such as munis and EM.