Karen Pierog, Saqib Ahmed Iqbal

(Reuters] – Investors reeling from gyrations on the bond markets are looking ahead to see if the Federal Reserve can reduce asset purchases and tighten its policy to manage stubbornly high levels of inflation.

Fed policymakers will meet this week to discuss reducing central bank bond purchases. The central bank has been buying $120 billion per month in bonds backed by government securities in an effort to stabilize the economy following the economic downturn.

(GRAPHIC: In with a boom, out with a … – https://graphics.reuters.com/USA-FED/byvrjrggbve/chart.png)

Broadly telegraphed, the announcement that the move would occur in either mid-November or December has been made. The Treasury market has continued to churn as investors prepared for tighter policy. The expectations of investors that inflation will force the Fed into raising rates faster and sooner than expected have risen sharply. The yield curve has flattened and short-term rates have increased.

Chuck Tomes of Manulife Asset Management Boston said, “Once the taper is over, the next big event will be when the Fed looks to tighten going forward. That puts more emphasis on effective every major economic data point.” All of the major economic data points could see more volatility.

Bank of America (NYSE 🙂 stated in a report that the bond market gyrations have likely already led to losses for some leveraged hedge funds. Investors could be renegotiating positions in order to avoid further losses. Deutsche Bank (DE)

Wall Street banks have been intensifying tapering preparations to make sure they can handle market volatility spikes.

Still, there could be unexpected outcomes. According to Steve Bartolini (portfolio manager, U.S. Core Bond Strategy at T. Rowe Price), not tapering at this stage could significantly steepen U.S. Treasury yields curve. However, a quicker-than-expected program of tapering would result in a significant flattening.

This time, the Fed’s communications are in stark contrast to 2013, when bond yields rose significantly during what was called the “taper tantrum”, after Ben Bernanke (then Fed chief) unexpectedly informed lawmakers that the central bank might slow down its asset purchases. These were assets used for bolstering markets. The benchmark 10-year U.S. Treasury yields rose to around 3.3% from 2% in May 2013.

Although the change isn’t as drastic, it is still a significant one for the U.S. Bond market. It is currently on the verge of its first loss annually since 2013.

(GRAPHIC: Rough sledding in the bond market – https://graphics.reuters.com/USA-FED/INVESTORS/akvezadxmpr/chart.png)

PRICE WORRIES

Investors pay attention to rising inflation. They will be watching the Fed meeting to determine if Jerome Powell’s assertion that prices would rise over time is still valid.

Tom Martin, Senior Portfolio Manager at Globalt Investments, Atlanta said that while long-term yields will fall after the taper announcement, rising borrowing costs are a major headwind to growth.

Martin stated that they are worried that the central banks could mistakenly raise interest rates too soon. He said that Martin had been “prepared for interest rates not to rise for quite some while and that we remain firm in that position.”

Stephen Tally (chief operating officer at Leo Wealth) stated the risk that inflation is “not as transitory” as they’ve been led believe. This “pushes Fed farther and quicker than they want.”

Last week saw inflation expectations rise with the 5- and 10-year breakeven rates for inflation reaching their highest level in over a decade.

Lon Erickson of Thornburg Investment Management, said that “where it’s going be more dicey” is the way in which Powell uses transitory to describe a situation and then puts a timeline around it.

Bryce Doty, Senior Portfolio Manager at Sit Investment Associates, said that he’s been tweaking portfolios lately with an eye to rising inflation.

Doty indicated that she believes you should still be investing in TIPS or any product with inflation protection.

Powell’s uncertain tenure as Fed Chair has played into market movements. He places rate increases in a different box to tapering. Higher interest rates are dependent upon full employment returning and inflation exceeding the Fed’s goal of 2%. However, this level is moderately higher for a while.

Investors are closely monitoring monthly job reports. October’s is due Friday.

Jason England is the global bond portfolio manager for Janus Henderson Investors. He said, “Is it possible that after a weak September number they will rely on that October number to start really getting into discussions about rate hikes?”