Mr. Taper and Punch Bowls

by | May 24, 2021

First the Fed, now the ECB.

Last Friday, in response to a journalist, Christine Lagarde declared that it is ‘far too early’ to consider tapering ECB asset purchases. Her attempt to dismiss an unwelcome question is reminiscent of the Fed’s efforts to talk down taper. Yet the steadfast refusal of the Fed or the ECB to engage in taper talk is at odds with the approaches taken by the Bank of Canada and the Bank of England, which have already taken steps to slow bond buying.

No matter what central bankers may prefer, taper talk has arrived. And like an annoying houseguest who never leaves the party, this Mr. Taper and his talk won’t go away just because central bankers say so. Moreover, obstinacy could make matters worse.

Here’s why.

Global growth is surging past already high expectations. More firms are reporting bottlenecks in procurement, production and distribution. Prices and wages are beginning to climb. It is hardly surprising that journalists and investors should begin to ask central bankers tough questions about easy money policies.

By refusing to engage on the subject, and even more importantly, by asserting confidently that it is not warranted because accelerating inflation will be ‘temporary’, the Fed and the ECB risk spiking the markets’ punchbowls, creating a bigger mess down the road. A bit more uncertainty, on the other hand, could dampen investor exuberance before it becomes irrational.

Talk of tapering is also warranted given a booming world economy. China and the US have led the rebound, thanks to their earlier successes in reducing Covid-19 infection rates, hospitalizations and deaths. In the US, vaccination has been decisive in permitting the resumption of economic activity. Despite a more sluggish vaccination rollout, the EU is now beginning to see improved growth, particularly as export demand lifts goods production. While India and Brazil struggle with the pandemic, other emerging economies are recovering, boosted by soaring commodity demand and prices, alongside accelerating world trade growth. Those trends have been underscored by the latest purchasing manager surveys and a raft of other positive data.

Accordingly, output gaps are closing more rapidly than anticipated. Accelerating economic activity has also outpaced employment growth beyond what is typically seen during recoveries. Labor market rigidities, including lower participation rates among some groups, are impeding re-hiring. Bottlenecks are also becoming more apparent in product markets.

Barring a recurrence of the pandemic, global growth will remain robust over the remainder of 2021. Economic re-opening will occur in successive waves across the world economy, reinforcing activity via trade and production linkages. Although US fiscal support will probably wane by early 2022, it now provides a strong tailwind. 

As noted, some central banks have already begun to make adjustments. Also, the latest Federal Reserve Open Market Committee minutes suggests that the Fed will soon debate when to scale back asset purchases. If so, consistency of communication will imply that the Fed will have to change its language, moving away from confident assertions that inflation will be ‘transitory’ and adopting messages that express more balanced views on growth and inflation. 

It is clear that taper talk has arrived, and it won’t go away easily. So, what does this mean for the markets? 

Bonds are first in line. Over the past nine months, yield curves have steepened, as rising long-term inflation expectations have driven up longer maturity bond yields, while central banks have held short rates down with resolve that policy will not change soon. Accordingly, shorter-dated notes are most vulnerable to taper talk. Long-term yields will also rise, but the most likely outcome is a flatter yield curve.

For equities, much depends on what tapering means for growth and earnings. If tapering is only about tapping the brakes to prevent unwelcome inflation and to promote a long expansion, investors will continue to shift from pricey growth stocks to cheaper cyclical shares. But given that earnings growth is already peaking, and broad market valuations are elevated, talk of taper will coincide with more pedestrian equity returns.

The chief concern remains surging inflation and a jump in long-term inflation expectations. That outcome spells trouble for stocks and bonds, given that central bankers would tighten more quickly and aim to slow growth. Investors would find few places of refuge. Some assets that might perform, such as cryptocurrencies, come with lots of uncertainty. Gold and commodities could do well, but if the US dollar surges history suggests poor performance.

In short, taper talk matters. Neither investors nor central bankers can wish it away.

No one likes an unwelcome guest who won’t leave a party. For central bankers, that guest is the voluble Mr. Taper. And annoying as he may be, Powell and Lagarde must not let him distract them, lest they forget that their primary job is to ensure that the punch bowl is removed before the party, not the guest, becomes the problem.

About the Authors

Larry Hatheway

Larry Hatheway has over 25 years experience as an economist and multi-asset investment professional. He is co-founder, with Alexander Friedman, of Jackson Hole Economics, LLC, which offers commentary and analysis on the global economy, policy & politics, and their broad implications for capital markets. Prior to co-founding Jackson Hole Economics, LLC Larry worked at GAM Investments from 2015-2019 as Group Chief Economist and Global Head of Investment Solutions, where he was responsible for a team of 50 investment professionals managing over $10bn in assets. While at GAM, Larry authored numerous articles on the world economy, policy-making and multi-asset investment strategy. Larry was also the lead investment manager for various mandates, funds and an actively managed multi-asset index. Larry also served on the GAM Group Management Board, was Chairman of the GAM London Limited Board and served as member of the GAM Investment Management Limited Board. Larry was also Chairman of the GAM Diversity & Inclusion Committee. During his tenure at GAM, Larry was based in London, UK and Zurich, Switzerland. From 1992 until 2015 Larry worked at UBS Investment Bank as UBS Chief Economist (2005-2015), Head of Global Asset Allocation (2001-2012), Global Head of Fixed Income and Currency Strategy (1998-2001), Chief Economist, Asia (1995-1998) and Senior International Economist (1992-1995). During his tenure at UBS, Larry was also a standing member of the UBS Wealth Management Investment Committee. While at UBS, Larry worked in Zurich, Switzerland, London, UK (various occasions), Singapore and Stamford, CT. At both GAM Investments and UBS Investment Bank Larry was widely recognized for his appearances on Bloomberg TV, CNBC, the BBC, CNN and other media outlets. He frequently published articles and opinion pieces for Bloomberg, CNBC, Project Syndicate, and The Financial Times, among others. Before joining UBS in 1992, Larry held roles at the Federal Reserve (Board of Governors), Citibank and Manufacturers Hanover Trust. Larry Hatheway holds a PhD in Economics from the University of Texas, an MA in International Studies from the Johns Hopkins University, and a BA in History and German from Whitman College. Larry is married with four grown children and a loving Cairn Terrier, and resides in Wilson, WY.

Alex Friedman

Alex Friedman is the co-founder of Jackson Hole Economics, LLC, a private research organization which provides analysis on economics, politics, the environment and finance, and develops actionable ideas for how sustainable growth can be achieved. Friedman is a senior leader with two decades of experience growing and transforming organizations in the financial and non-profit industry. He was the CEO of GAM Investments in London and chairman of the firm’s executive board. Previously, he was the Global Chief Investment Officer of UBS Wealth Management in Zurich, chairman of the UBS global investment committee, and a member of the executive board of the private bank. Before moving to UBS, Alex Friedman served as the Chief Financial Officer of the Bill & Melinda Gates Foundation. He was a member of the foundation’s management committee, oversaw strategic planning, and managed a range of the day-to-day operating functions of the world’s largest philanthropic organization. Friedman also created the foundation’s program-related investments group, the largest impact investing philanthropic fund in the world. He started his career in corporate finance at Lazard. Friedman served as a White House Fellow in the Clinton administration and as an assistant to the U.S. Secretary of Defense. He is a member of the board of directors of Franklin Resources, Inc. (Franklin Templeton), a member of the Council on Foreign Relations, Chairman of the Advisory Board of Project Syndicate and a board member of the American Alpine Club. Friedman is a regular contributor to a range of newspapers and thought leadership groups and is also the author of Babu’s Bindi, and The Big Thing, both children’s books. He is an avid mountaineer and rock climber and led the first major climb to raise money for charity through an ascent of Mt. McKinley. Friedman holds a JD from Columbia Law School, where he was a Harlan Fiske Stone Scholar, an MBA from Columbia Business School, and a BA from Princeton University.

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