Saqib Ahmed Iqbal

NEW YORK (Reuters) – Investors are watching everything from bond volatility to inflation measures as they try to gauge how an expected unwind of the U.S. Federal Reserve’s easy money policies will reverberate throughout markets.

The majority of market participants think that the Fed will announce at Wednesday’s November meeting the time when the U.S. government backed bond buying program of $120 billion per year is to be tapered.

(GRAPHIC: Fed’s balance sheet – https://fingfx.thomsonreuters.com/gfx/mkt/zdvxorlyrpx/Pasted%20image%201635797906162.png)

It has done everything it can to make investors feel comfortable about the taper. Investors have not been affected by the gyrations experienced in 2013. This was after Ben Bernanke, then Fed chief, made reference to Bernanke’s plans to cut back its monetary assistance in an appearance in front of lawmakers. Bond yields rocketed higher and stock prices dropped during the so-called “taper tantrum” that year. The Fed slowly unwound $85 billion of government bond purchases in 2014, and yields fell while stock prices rose.

While stocks are at new highs, shifting expectations about how aggressively Fed officials will move to curb inflation have caused volatility in rates for Treasury securities with shorter maturities.

Bryce Doty (senior portfolio manager, Sit Investment Associates) stated that it is difficult to predict what it will mean when the central bank suddenly stops buying $120 billion worth of securities every month. But once the central bank stops buying securities, it has an effect.”

Investors are paying attention to these metrics.

(GRAPHIC: Breakeven inflation rates – https://fingfx.thomsonreuters.com/gfx/mkt/znpnezydkvl/Pasted%20image%201635798624668.png)

INFLATION

Ten-year breakeven rate, which is a measure of inflation expectations by measuring the yield spread 10 years Treasury Inflation Protected Securities or TIPS and, stands at multi-year highs. This suggests that investors are more confident the current bout may be lasting longer than anticipated.

There are signs that the central banking is changing its mind about inflation and this could raise expectations as to how soon policymakers raise rates.

Tom Martin (senior portfolio manager, Globalt Investments) stated that they are concerned about the possibility of the central banking making a mistake by raising interest rates too soon.

According to the Fed’s latest “dot chart”, about half of policymakers see the Fed raising rates before the end next year. The other half expects liftoff at the end 2023.

(GRAPHIC: S&P dividend yield vs 10-year U.S. Treasuries – https://fingfx.thomsonreuters.com/gfx/mkt/myvmngdmmpr/Pasted%20image%201635796129587.png)

DIVIDEND YIELD

The spread between the yields of the 10-year Treasury bond benchmark and the yield on the newly opened dividend note has been at its largest since May 2019 which could make it less attractive to income-seeking investors.

The yield on 10-year Treasury bonds is already up about 67 basis points from this year’s low and may rise further as investors factor in interest rate increases from the Fed.

Stephen Tally (chief operating officer of Leo Wealth) stated that “it really means that interest rate increases are going to happen in the future and that that will have an impact on stock prices.”

(GRAPHIC: Bonds on the move – https://fingfx.thomsonreuters.com/gfx/mkt/gkvlgxrmgpb/Pasted%20image%201635796495338.png)

VOLATILITY

As global markets battled the pandemic, near-zero interest rate and large monthly bond purchases helped to calm fears and mitigate volatility.

As investors prepare for the Fed taper, and possible rate rises, some of this volatility is starting to creep back in. The ICE (NYSE: ) BofAML U.S. measures investors’ expectations regarding Treasury market gyrations. The Bond Market Option Volatility Estimate Index is near its post-pandemic peak.

Ebbing central bank support and the prospect of policy tightening “puts more importance on effectively every major economic data point that comes out,” said Chuck Tomes, associate portfolio manager at Manulife Asset Management in Boston.

(GRAPHIC: Rising reverse repo – https://graphics.reuters.com/USA-FED/znpnezrrmvl/chart.png)

REPO FACILITY

Some investors will be watching the usage of the Fed’s overnight reverse repurchase agreement facility as a proxy for how less accommodative monetary policy is affecting liquidity in the market.

This facility allows counterparties such as money-market funds to deposit cash at the central bank. The volume of the Fed’s overnight reverse repurchase agreement facility recently hit a record $1.6 trillion.

Markets are more liquid and therefore less susceptible to disruptions, based on the strong volume. An analyst said that signals of liquidity being in decline as the Fed pulls its support could be a sign for riskier assets.

Bryce Doty, Sit Investment Associates said that the repo facility is “the canary in the coalmine”.