U.S. Treasuries have continued to disappoint since our May 20 note that viewed “weakness as a buying opportunity.” Increased speculation about the imminence of the Fed’s tapering its asset purchase program, commonly referred to as QE3, is largely to blame; however, the market’s ultimate reaction to such a move is anything but clear.
First of all, tapering and tightening are not the same thing. Tightening is tantamount to stepping on the brakes, while tapering is akin to easing up on the gas pedal. Whether this analogy holds true depends on which “effect” the market is more sensitive to.
The “stock effect” view of asset purchases would argue that tapering is still an accommodative policy, as the Fed’s balance sheet would continue to grow, albeit at a slower pace. Conversely, the “flow effect” view would see decreased purchases as a tightening policy, as the monthly pace of purchases would have declined, reducing downward pressure on interest rates.
Either way, it is important not to view potential tapering in isolation. One of the secondary benefits of the QE programs was easy funding of the U.S. government’s huge deficits, which themselves blunted the efficacy of the bond-buying programs, and which (post-sequestration) have been reduced to almost half of what they were relative to GDP only two years ago.
Therefore, even reduced asset purchases could be able to produce the desired effect of lower interest rates, and actual tightening, by means of either shrinking the Fed’s balance sheet or raising interest rates, still seems to be a distant event.