Taper Tantrum 2: Is there a sequel in the making?
Sequels – occasionally they’re better (The Godfather Part II), but most of the time they’re worse. Often far worse (Jaws: The Revenge).
As investors and economists look for the next market risks after the pandemic, some are now expecting a follow-up to 2013’s blockbusting Taper Tantrum. This sequel could even be coming to (trading) screens near you as soon as 2021.
Whether it will be more enjoyable – or more dramatic - than the original remains to be seen.
What was the plot of the original Taper Tantrum?
The backstory centred on the Global Financial Crisis of 2008. As the whole financial sector teetered on the brink of collapse, the Federal Reserve (Fed) – directed by then-chair Ben Bernanke - introduced its now well-known policy of quantitative easing (QE).
This involved buying up large amounts of bonds and other securities, with the goal of increasing liquidity and stability in the financial system, and encouraging lending. This was supposed to stimulate economic growth by reducing the cost of borrowing, getting consumers spending and businesses investing again.
The policy worked. Between 2008 and 2013 the Fed bought almost $2 trillion in US government bonds (Treasuries) and other assets. Markets recovered strongly.
Arguably QE worked too well, as investors came to rely on this massive market support.
Then came the twist…
In 2013 Bernanke announced that the Fed would, at some point, start to reduce – or “taper” - the amount of asset purchases it was making.
In so doing, the Fed chair learned an important lesson in how not to script an exit strategy.
Investors - spooked that the world’s largest buyer of bonds was apparently exiting stage left – reacted badly to his announcement.
US Treasuries immediately sold off and the value of the US dollar shot up. Emerging markets suffered, particularly the “fragile five” of Brazil, India, Indonesia, Turkey and South Africa, as foreign capital was withdrawn and their currencies depreciated sharply.
Taper Tantrum 1: How the Fragile Five’s currencies responded
Source: Refinitiv/Datastream. 600206
This became known as the Taper Tantrum. It was called a tantrum as - like a child whose comfort blanket has been taken away – it was seen as an overreaction.
Once the tapering actually started, markets continued to recover rather than collapse.
Why are some investors fearing a sequel?
Speculation abounds that a big budget follow-up is in the making. This time, Covid-19 is the backdrop.
The level of support provided by governments and central banks since the pandemic swept the world dwarfs that of the first time around. This has helped economies to keep ticking over and markets to shrug off the effects of the virus and hit new highs.
The US government alone had spent around $2.6 trillion on fiscal stimulus packages by October 2020, most of which was accounted for by the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) which totalled around $2 trillion.
Meanwhile, the Fed has helped prop up bond markets through its gargantuan QE programme. The Fed’s balance sheet (the total assets and liabilities it holds) has soared to $7 trillion.
Since June, the Fed has been buying $120 billion of Treasuries and mortgage-backed debt a month. The intention behind it was to stabilise markets, but also to support the economy by keeping long-term interest rates low. With bond yields and interest rates suppressed by this market support, investors have sought out riskier assets to generate their returns or meet their liabilities.
However, as vaccines continue to roll out and a return to normality becomes a less dim prospect, QE will moderate.
What might ha