Fed Taper Likely to Push Real Yields Higher

October 7, 2021

Source: Bloomberg Source: Bloomberg

The Federal Reserve’s (Fed) rapid response to the COVID-19 crisis last year included several extraordinary monetary policy actions, including a fourth round of large-scale asset purchases or quantitative easing (QE). This week’s chart highlights the dramatic impact recent Fed purchase activity continues to make on valuations for Treasury Inflation-Protected Securities (TIPS). 10-Year TIPS yields (or real yields) declined deeply into negative territory after the Fed renewed the QE program and remain near the lowest levels seen since TIPS were first issued nearly 25 years ago.    

The Fed’s ownership of TIPS increased substantially following its most recent round of QE and now represents more than 25% of the total TIPS market. Numerous factors have contributed to the sharp fall in both nominal and real yields during the past 18 months, but QE ranks near the top. The long-standing mantra of “don’t fight the Fed” has given bond investors a green light to take risk, keeping interest rates and credit spreads near historic-low levels.

Key Takeaway

The Fed is likely to begin its long-anticipated tapering process following next month’s Federal Open Market Committee (FOMC) meeting. Even though tapering does not mean the Fed will be selling assets or reducing the size of its nearly $8.5 trillion balance sheet. Valuations for TIPS, which have historically traded with less liquidity than nominal Treasury bonds, are vulnerable should the Fed move at a faster pace toward normalization of monetary policy than bond markets are pricing in today.

Tags: Federal Reserve | COVID-19 pandemic | Quantitative easing (QE) | Treasury Inflation-Protected Securities (TIPS) | Credit spreads | Tapering | FOMC | Bond markets | Monetary policy | Real yields

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