The extent of the impact of tapering [1] will depend on various channels. In addition to a rebalancing of portfolios toward substitutable securities, other effects may come into play:
Wealth effect: The Fed’s purchases of securities, particularly MBS, have stabilized and boosted real estate prices, which has helped reduce US household debt and boosted consumption through the resulting increase in wealth. The Fed’s support for the US economy has also led to an increase in the price of other assets, such as equities. The wealth effect of this slowdown in securities purchases – and therefore de facto less support for the US economy – would therefore tend to limit the rise in interest rates.
Signal effect: The implementation of tapering signals an end to highly accommodative monetary policies. This convergence makes the upcoming rise in key interest rates all the more credible and therefore leads to more pronounced expectations of short-term rate hikes. This effect is currently offset by the strengthening of forward guidance.
Effect on liquidity premiums: The reduced inflow of liquidity – in the macroeconomic sense, i.e., the reduced injection of money into the economy by the Fed – following the reduction in the size of the asset purchase programs may lead to an increase in the liquidity premium[2], particularly on bonds, where the various QE programs have significantly compressed it. This refers to market liquidity, i.e., the ease with which agents can trade securities on financial markets without affecting prices.
Effect on asset prices: Portfolio rebalancing may also be detrimental to assets that are not substitutable for the old securities purchased under QE3. This is the case, for example, with stock market assets which, although supported by a positive economic situation, may face lower demand as tapering gains momentum.
Finally, the improvement in the economic situation is conducive to an increase in real rates and expectations of higher short-term rates, and therefore a rise in long-term rates.
