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Tapering? Maybe this year, maybe not

The July meeting minutes of the Federal Open Market Committee didn’t shed light on whether the Federal Reserve will announce its tapering plans in September or November, according to a new report from Moody's Analytics. There isn’t a consensus on when it will be appropriate to start dialling back the central bank’s monthly asset purchases. If it is going to taper by the end of this year, odds are the Fed will need to announce the coming move by September.

The Fed has stressed that it will provide markets plenty of advance notice, so it is unlikely to make an announcement in November and start the taper in December. Moody's Analytics says that its assumptions were not changed by the July minutes and still anticipates the initial tapering in January 2022. However, the August employment report will be key in assessing if the Fed will taper sooner. The July minutes suggest that the US labour market hasn’t made "substantial" progress yet, and that is the last piece that the Fed wants in place before it acts.

Various July FOMC participants commented that economic and financial conditions would likely warrant a reduction in the coming months. However, several others indicated that a reduction in the pace of asset purchases was more likely to become appropriate early next year. Those participants saw prevailing conditions in the labour market as not close to meeting the committee's "substantial further progress" standard or were uncertain about the degree of progress toward the price-stability goal.

Those favouring tapering this year are likely some of the hawkish regional Fed presidents, while those who believe tapering could occur early next year likely include the Fed Chairman, Jerome Powell.

When the Fed does announce its tapering plans, which Moody's believe will happen later this year, the July minutes show it will try to hammer home the point that there isn’t a link between tapering and the timing of the central bank’s first rate hike. Markets assumed there was a link in 2013 when the 'taper tantrum' occurred.

MBS purchases not significantly distorting markets

The Moody's Analytics baseline forecast assumes the Fed adopts a balanced approach to tapering its monthly treasury and mortgage-backed securities (MBS) purchases, but some Fed officials favour focusing initially on reducing MBS purchases because of the red-hot housing market.

During a crisis, Fed MBS purchases support housing as a buyer of last resort. The Fed’s MBS purchases since restarting them during the pandemic have helped the housing market but narrowed mortgage spreads. However, it's not just the Fed that is behind the booming housing market. Fundamentals are a bigger driver. Demographics and pent-up demand have led to a surge in home sales. Though some fear a bubble, this housing market is significantly different than during the last bubble. Lending requirements are more stringent today than 20 years ago, when the eventual tightening came in efforts to limit subprime lending. Unlike the mid-2000s, people these days can actually afford the homes they are buying.

Still, the Fed should avoid linking house price growth and MBS purchases because this could have political costs down the road. The Moody's report says it does not believe there is a bubble in the housing market, but if one does develop, a lot of fingers will be pointed at the Fed and could have some lawmakers attempting to label the Fed’s asset purchases as reckless.

The Fed’s MBS purchases haven’t caused enormous distortions in mortgage spreads recently. The spread between the Freddie Mac 30-year fixed mortgage rate and the 10-year US treasury yield was 156 basis points last week. This is only modestly lower than its pre-COVID-19 average in 2018 and 2019 of 171 basis points and its historical average of 170 basis points. Therefore, outside of a crisis, the Fed’s MBS purchases' impact on spreads is modest. So, when the Fed does begin to taper, there shouldn’t be a huge impact on spreads, since there is plenty of investor demand for MBS. Normally, the main driver of consumer-facing mortgage rates is the 10-year treasury yield. Spreads are affected by many other factors, including the capacity of loan originators.

The Fed’s MBS purchases have helped lower borrowing costs for potential homebuyers, which has boosted sales. At first glance, there is no correlation between year-over-year growth in the Case-Shiller Home Price Index and the change in the Fed’s MBS holdings. However, since MBS purchases first occurred in 2009, the correlation coefficient is 0.1. Moody's Analytics also double-checked to make sure that the MBS share of all assets held outright on the Fed’s balance sheet isn’t what matters. The correlation between house price growth and the MBS share of total assets held outright by the Fed is -0.05 since 2009.

Correlations change significantly if you focus on times that the Fed goes on an MBS purchase binge, including in 2009 and since the pandemic began. For example, the correlation coefficient between house price growth and MBS purchases since the pandemic started is 0.57.

Correlation doesn’t imply causation. Therefore Moody's Analytics used Granger causality tests to see if there is a causal relationship between house price growth and the Fed’s MBS purchases and to see way it ran. We tested with various lags, and MBS purchases were found to Granger-cause changes in house prices. The results showed that the causality runs one way, which isn’t surprising.

Though there is a causal relationship, MBS have played a small role in the recent acceleration in house prices; therefore, the start of tapering would put only a little downward pressure on prices. Home sales should remain strong, supported by a demographic tailwind. The issue is on the supply side. New- and existing-home inventories are lean. The demand-supply imbalance is the primary reason for house prices' recent run-up, not the Fed.

Behind the widening in high-yield spreads

Moody's has lowered its forecast for the US high-yield option-adjusted corporate bond yield in the second half of the year but risks remain heavily weighted toward a tighter spread. Its August baseline has the high-yield option-adjusted corporate bond spread averaging 333 basis points in the second half of this year, 30 basis points tighter than in the July baseline.

The firm says it expects spreads to widen in the fourth quarter, ending the year near 400 basis points. The high-yield corporate bond spread has widened over the past several weeks and should gather momentum in the final three months of the year as long-term rates increase and stock market volatility picks up because of the Fed announcing its tapering plans and a likely debt-ceiling battle. The widening coincides with a recent drop in the VIX, which seems odd. It appears that the bulk of the widening in high-yield corporate bond spreads is attributed to a drop in global oil prices.

The correlation coefficient between changes in the high-yield corporate bond spread and changes in West Texas Intermediate crude oil prices is -0.63. Again, correlation does not imply causality, so Moody's Analytics used Granger causality tests to see if there is a causal relationship between the high-yield corporate bond spread and West Texas Intermediate crude oil prices. With no lags, fluctuations in WTI crude oil prices were found to Granger-cause changes in the high-yield corporate bond spread. The results showed that the causality runs one way, which isn’t surprising.

Therefore, high-yield corporate bond spreads could continue to widen if the spreading Delta variant of COVID-19 reduces demand for oil. The Delta variant has infiltrated China. This has significant economic ramifications, not least due to the government’s zero-tolerance approach to new infections. There are cases in around half of China’s 31 provinces and the government has introduced nationwide restrictions since mid-July. Other countries in the Asia-Pacific region have also tightened restrictions to contain the spread of COVID-19. This could put some additional downward pressure on oil prices within the next couple of weeks, leading to wider US high-yield corporate bond spreads.

Normally, a widening in the high-yield corporate bond spread raises a red flag because of the external finance premium - the difference between a firm’s cost of borrowing and raising funds internally. Corporate yield spreads are a proxy for this premium. However, this time is likely different, as high-yield bond spreads are noticeably tighter than their historical average of 505 basis points.

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