Must-know: Why the taper caused yields to increase

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Dr. Stein on monetary policy communication: Overview (Part 2 of 8)

(Continued from Part 1)

Reaction to the hint of taper in June 2013

Much of the current theoretical base of finance assumes that investor expectations are comparable. In other words, all the investors expect a similar outcome.

In reality, however, this is not the case. Investors have different opinions and expectations of the market’s potential course. This was the first challenge Dr. Stein mentioned in his speech “Challenges for Monetary Policy Communication” to the Money Marketeers of New York University on May 6, 2014.

Dr. Stein quoted an example of the spike in Treasury yields after the Fed’s June 2013 meeting where then Chairman Ben Bernanke hinted at tapering for the first time. In early May 2013, the long-term Treasury yields were around 1.6%. They spiked to 2.7% shortly after the June 2013 Federal Open Market Committee (or FOMC) meeting. The increase occurred even though there was no major change between April and July 2013 in the expectation of median respondent to the Fed’s survey on the ultimate size of the asset purchase program.

While the expectation of the size of the asset purchase program change slightly, the respondents felt that they didn’t have any clear directional implications for the total amount of accommodation to be provided through asset purchases.

One hypothesis that Dr. Stein presented was that there were different opinions among market participants on the future of the asset purchase program. However, the median expectation primarily remained the same.

There were optimists who expected the asset purchase program to continue long-term. These traders immediately went short on bonds, but their optimism suddenly disappeared after then Chairman Bernanke made the statement regarding the tapering. The traders’ positions caused the yields to spike.

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 increase in interest rates.

To learn more about why FOMC’s forward guidance has become more qualitative and less deterministic, continue reading the next part of this series.

Continue to Part 3

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