The U.S. Federal Reserve surprised the markets by announcing its decision to postpone reducing the purchase of Treasury and agency mortgage-back securities. The Board of Governors said the central bank will continue buying $45 billion in Treasury bonds and $40 billion in agency MBS every month “until the outlook for the labor market has improved substantially in a context of price stability.”1 But it is inevitable that the Fed will start winding down its purchase program when labor market conditions improve and inflation expectations are within tolerance. How will equities and other risky assets be affected? Understanding the impact of tapering across asset classes and market sectors may enable investors to take advantage of the Fed’s reprieve and position their portfolios advantageously.
In the United States, the prospect of tapering, which is understood as the prelude to eventual tightening, has had the immediate effect of an upward shift in the Treasury yield curve and a bludgeoning of long bonds.2 It has also sent shockwaves to other asset markets; emerging market (EM) bonds, in particular, have declined significantly in sympathy. It warrants exploring why rising yields on U.S. Treasuries could affect prices of all income oriented instruments so significantly.
Historically, risky assets have exhibited varying degrees of interest rate sensitivity. Pro-cyclical assets, such as equities, real estate, high yield and emerging market bonds have historically displayed negative correlations with Treasury bonds over annual and longer horizons (Table 1). In normal conditions, interest rates provide information on economic growth. Rising rates suggest faster GDP growth, better ROIs and a greater demand for investment capital. These positive factors, in turn, also drive better corporate earnings growth and improve household, corporate and export-oriented EM balance sheets.