September 15, 2013 12:50 pm

US bond investors expect Fed to announce small ‘taper’

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US bond investors expect a modest reduction in bond purchases this week as the Federal Reserve gears up for a fateful decision on whether to slow its third round of quantitative easing.

The Fed will need to pitch its communication perfectly in order to avoid further market turmoil after the prospect of a “taper” in QE3 purchases from $85bn-a-month sparked a jump in interest rates.

The amount and format of any taper agreed at Wednesday’s policy meeting will send a powerful signal to markets about the aggression of future Fed moves and could spark renewed volatility across global markets.

Benchmark 10-year Treasury yields, which move in the opposite direction to prices, have nearly doubled since the Fed started hinting at a taper in May and recently peaked at 3 per cent, before showing evidence of stability in closing last week at about 2.9 per cent.

Solid investor demand for Treasury sales of 10- and 30-year paper at current yield levels bolsters the view that bond markets have priced in a modest Fed taper. The New York Fed has surveyed bond dealers to find out how they expect it to move.

“The bond market expects a taper, the only question is whether it is $10bn, $15bn or more,” said Ian Lyngen, strategist at CRT Capital. He said the solid demand for last week’s Treasury debt sales showed that a 3 per cent yield on the 10-year note represents a near-term ceiling.

Also boosting near-term sentiment for bonds is the expectation that the central bank will lower its forecasts for the US economy for this year.

A bullish surprise for the Treasury market may loom in the form of a smaller taper, about $10bn or less, as the central bank tries to manage a reduction in QE3 against the backdrop of modest growth and low inflation.

“The market appears to be fairly priced in for a tapering announcement, but we believe that the risk is for a smaller-than-expected pace of tapering than is currently being priced in, somewhere in the order of $5bn to $10bn,” said Millan Mulraine, strategist at TD Securities.

In contrast, a taper of $20bn would be likely to spur a further rise in yields. “A $20bn taper would be very difficult for the bond market to handle,” said Mr Lyngen.

The Fed is also likely to reinforce its interest rate guidance message that the start of any tapering in QE does not mean rate rises will follow in due course. Earlier this month, the yield on two-year notes, which is very sensitive to expectations of tighter policy, climbed above 0.5 per cent, a level not seen since May 2011.

Alan Levenson, chief economist at T Rowe Price, said: “The committee may consider strengthening the interest rate guidance to reinforce its expectation of a gradual pace of policy renormalisation, as well as to curtail any tendency for markets to discount a more aggressive fed funds rate path in response to a change in the asset purchase programme.”

The sharp rise in yields since May has hit bond investors hard and the Barclays US Treasury bond index has registered a total return of minus 3.2 per cent this year, while an index of long-dated bonds has slumped 12.5 per cent.

In contrast, during September the S&P 500 has recovered from much of last month’s losses and is just 1.2 per cent shy of its record close in early August.

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