Janet Yellen, Interest Rates, the Fed and the Tapering Threat

On Tuesday, the Senate held a confirmation hearing for President Joe Biden's nominee for Treasury Secretary, Janet Yellen. It is likely that Yellen will oversee a massive increase in the U.S. debt load, as Biden's proposed Covid relief and infrastructure plans would total something like $4 trillion. How will this impact interest rates?

Also in the last week, some Federal Reserve officials have begun talking about when it might be time to scale back their purchases of government bonds. How likely is this? And could it become a replay of 2013's "taper tantrum?"

Here are my thoughts on both.

Growth, Not Debt Levels, Will Push Interest Rates

During her Senate hearing, Yellen talked extensively about the need to "act big" to boost the economy now. As I said above, this probably involves both immediate aid to consumers as well as intermediate-term spending on infrastructure programs. In addition, Yellen said that now wasn't the time for tax increases, even those targeting the wealthy. While she said the Biden Administration may favor rolling back some parts of the 2017 tax bill, it wasn't something they would consider while the pandemic was still ongoing. Hence, we can assume any new spending will be entirely debt financed.

We can't know exactly how much of these spending plans will pass Congress, but the base case should be that much of it will. Not only have the Democrats taken control of the Senate, but it also seems likely that these spending programs will be reasonably popular.

This should impact U.S. interest rates in a few ways. There will be a direct effect of greater Treasury supply. I believe this effect will be minor as it is probably already priced in. The major impact will be from growth and inflation. If the economy does rebound strongly in 2021, perhaps in part because of federal spending, that will be the driver of interest rates.

How Much Debt Is Too Much?

This is one of the questions I get most often from clients or readers, and unfortunately the answer is "I don't know." Among the reasons why global interest rates are much lower now than in decades past has to do with a persistent imbalance between global savings and available investments. This probably has something to do with the rise of the Chinese economy and the investment/consumption imbalance that has long been an issue there. The drop in private investment by U.S. companies is probably also part of it. It may also be the increase in wealth imbalance may also be part of the problem, as wealthier people save more than those less well-off.

Ostensibly the government could soak up some of that excess savings through borrowing, and could even make up for a lack of private investment by funding long-lived infrastructure projects. If they pulled this off, interest rates would rise not because there's too much debt, but because there would finally be the right amount of savings.

In reality, it would be impossible for the U.S. government to get their debt issuance just right to perfectly offset all of the other imbalances. But crucially this means that the problem isn't that there's not enough demand to buy Treasury bonds, but that there's too much demand for safe investments generally. That tells me we're a very long way away from there being too much U.S. debt issuance.

Taper Tantrum 2.0?

Of course, the more immediate reason why U.S. rates are so low is Fed policy. On that end, a couple of Fed officials sounded like they were signaling the level of Fed accommodation could change sometime in 2021.

Both the Atlanta Fed's Raphael Bostic and Dallas Fed's Robert Kaplan said they may support "tapering" QE purchases if the economy does rebound strongly in the second half of 2021. Readers may remember this same term was used by Fed officials in 2013, as they were considering exiting from the QE2 program. This touched off the so-called "taper tantrum" where interest rates rose rapidly and stocks briefly nose dived before rebounding.

This begs two questions. One is whether this tapering threat is real. That one is easy: it isn't. First of all, with all due respect to Bostic and Kaplan, the decision to start reducing QE purchases will be made primarily by the Fed Chair. The Fed isn't like the Supreme Court or some congressional committee. Every vote doesn't really count. Regional Presidents only have real power to the extent that they are influential on the Chair.

For his part, Chair Jerome Powell has tried everything he can to sound as dovish as possible. This is because he learned the lessons from the Ben Bernanke Fed. Bernanke had good intentions when he was talking about tapering in 2013. He wanted to clearly telegraph the Fed's plans so as to not surprise the market. At the time the Fed thought that would reduce market volatility.

Unfortunately that didn't work, specifically because markets surmised that the taper talk meant that rate hikes must be around the corner. In other words, Bernanke found that QE wasn't just about the bond buying, it was also a signal about how the Fed felt about rate hikes.

Powell isn't going to make that same mistake. Powell is going to remain maximum dovish even after the pandemic has passed. In the days after Bostic and Kaplan made their comments, Fed Vice Chair Richard Clarida came out and said that he didn't see tapering in 2021, despite striking an optimistic tone about the economy overall.

Finally, readers may remember that Fed Vice Chair for Supervision Randal Quarles suggested that QE was beneficial for ensuring the orderly functioning of the Treasury market. With the supply of Treasury bonds on the rise, that should be all the more true in 2021.

There is a longer-term question to ask: When the Fed does eventually signal QE tapering (or for that matter, rate hikes) will we get a "tantrum" type response? No one can know for certain, but I think the answer depends on how closely the Fed hews to the average inflation targeting (AIT) strategy.

In the last recession, the Fed never really defined what it would take to start hiking rates. Worse, they often moved the goalposts. As a result, markets moved primarily on what the Fed said as opposed to incoming economic data. It should be the case that AIT changes that. In other words, the Fed's outlook shouldn't really matter anymore. It should just be whether inflation has risen such that a rate hike is justified.

In the old regime, if the economy was on the upswing and the Fed's forecast was optimistic, that would be enough for the Fed to hike. Under AIT, they should be waiting until inflation is actually above target for some period of time. That should mean that what the Fed says isn't so important as what actually happens in the economy.

So as for whether we could get a 2013-type rate spike, if the Fed waits for inflation data to dictate a hike, then interest rate volatility will depend on how volatile the data is. If they decide they need to pre-empt inflation after all, then interest rates will probably have another 2013-style tantrum. I think it will be the former, but it would help if people like Bostic and Kaplan would stick to the AIT message.

At the time of publication, Graff was short 10-year and Ultra 10-year Treasury Futures.