Interest rates and the taper
At the Federal Open Market Committee Meeting (or FOMC) meeting held on December 17–18, the Fed finally announced the onset of tapering. The Fed announced that it would reduce the amount of monthly purchases of agency-backed securities and longer-term Treasuries from $40 billion and $45 billion a month, respectively, to $35 billion and $40 billion a month, respectively.
How did interest rates react?
Following the Fed’s taper announcement, interest rates didn’t increase as much as expected. The market yield on U.S. Treasury securities at ten-year constant maturity rose by just 19 basis points (bps) from December 17 to December 31, 2013, to 3.04%. There were several reasons for this lack of significant change.
- Markets had been anticipating the onset of the Fed’s taper announcement for several months, and a large part of the increase in market yields had already been priced in the debt markets. The market yield on U.S. Treasury securities at 10-year constant maturity rose 1.34% from April 30 to December 31, 2013. The Fed had first hinted at tapering and exit strategies for its economic stimulus program at its meeting held on April 30–May 1.
- The $10 billion-a-month reduction in bond purchases was likely to precede other reductions as the Fed implemented its “exit strategy.” This meant that there would be lower market liquidity for carry trades (borrowing cheaply in low-yielding currencies and investing the proceeds in higher-yielding assets globally), precipitating flight-to-safety flows from higher-risk and higher-yielding emerging and frontier markets.
- The Fed would still continue to make $75 billion in bond purchases every month, which still was a very sizable volume and which provided a floor for bond prices.
Following the announcement, yields on the intermediate and longer-term Treasuries increased, with the greatest increases in the five-year and seven-year Treasury notes, which increased 21 basis points, to 1.75% and 2.45%, respectively to December 31, 2013. There was a practically negligible impact on the shorter-term maturities, as the Fed had indicated its intention to hold the rate at 0% to 0.25% until achieving its goals of full employment and 2% inflation.
To find out whether interest rates continued rising in 2014, move on to Part 7 of this series.