Why is the market expecting the taper to continue?



Well-aligned market expectations

Dr. Stein said that the Fed is “currently in a very good position with respect to the market’s expectations for our asset purchases going forward.” Markets now accept that the taper will continue at the current rate of $10 billion a month. At this rate, the asset purchase program would end by September or October of this year.

Since the market is expecting the taper to continue, it is much easier for the Fed to execute the taper. However, this wasn’t the case when Ben Bernanke, then chairman, first hinted at the taper during the Fed’s June 2013 meeting. Prices of major bond ETFs such as the Vanguard Total Bond Market ETF (BND), the iShares 20+ year Treasury Bond (TLT), the iShares 3–7 year Treasury Bond (IEI), the iShares 7–10 year Treasury Bond (IEF) and the iShares iBoxx $ Invst Grade Crp Bond (LQD) dropped when there was the hint of tapering in the Fed’s June 18-19, 2013 meeting on the expectation of monetary tightening and an increase in interest rates.

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The reaction to recent tapering decisions has been subdued, which confirms that the markets expect the taper to continue at the current rate. For example, while the Fed continued tapering the asset purchase program by $10 billion to $45 billion a month in its April 29-30 meeting, the yields across maturities didn’t see an increase. On the contrary, the yields dropped by two to four basis points for maturities over one year.

The rate of taper is accepted by the markets, but the timing of the increase in the federal funds rate remains a key variable. While the market expectations and the Federal Open Market Committee’s (or FOMC’s) decisions have formed a vicious circle regarding the tapering of Quantitative Easing 3 (or QE3), that isn’t always the case regarding monetary policy decisions.

To learn more about how policymakers react to the chain between market expectations and policy decisions being broken, continue reading the next part of this series.


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