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Talk of the Federal Reserve scaling back (tapering) and eventually ending its bond buying program (QE3) has resulted in a sharp rise in U.S. bond yields since early-May. Most of this can be attributed to an increase in the term premium, and is largely justifiable.
The remainder of the rise in yields is related to the pulling forward of expectations for the first rate hike and anticipation of a faster pace of subsequent monetary policy tightening -- neither of which is warranted.
Given that a September-taper is largely priced in, and assuming economic data cooperates, the Federal Open Market Committee (FOMC) is likely to act on September 18. However, risks remain with recent data slightly less supportive.
The taper is likely to be modest initially and weighed towards Treasuries, but its course will not be pre-determined. This will leave the FOMC several months of data to adjust policy if required.
Tapering does not constitute tightening, with the stance of monetary policy becoming more accommodative still -- this should be supportive for equities, especially amid a strengthening economy.
As it embarks on the taper, the FOMC is likely to concentrate on effectively communicating its forward guidance emphasizing that short-term rates will remain at current levels for a long time -- likely until mid-2015. This could lower bond yields a bit after the September meeting by more closely aligning market expectations to their own.
Aligning expectations may require the FOMC to alter its thresholds, or more firmly emphasize the notion that thresholds are not triggers.
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