James Mackintosh, writing in the WSJ, outlines two possible outcomes for financial markets when the Fed decides to taper its bond buying program. While it would seem logical that pulling back on a massive $1.4 trillion annual bond buying program should push bond yields higher, there is no guarantee. If investors view the Fed’s tapering decision as a sign of tighter monetary policy, it is possible yields will not rise much. We would still lean toward the former scenario playing out as we struggle to see what economic buyer would want to step in to fill a $1.4 trillion void left by the Fed at current yields, but it is worth contemplating the alternative.

 

Few people share my first uncertainty, because it seems so obvious that if the Fed buys fewer Treasurys, the price will drop and hence the yield rise. It is basic supply and demand, goes the response: Duh.

It is certainly true that all else equal, fewer bond purchases should mean a higher yield. But all else isn’t equal, because the Fed’s discussion of withdrawing stimulus shows a shift in mentality toward tighter monetary policy. Tighter monetary policy means less growth and inflation in the long run, and so lower long-term bond yields. The balance between the demand impact of less Fed buying and the perception of policy tightening will determine whether 10-year yields rise or fall, and it isn’t obvious to me which way they will go.

Wednesday and Thursday of last week provided an early test, as stocks and commodity prices dropped around the world after Fed minutes showed the central bank shifting toward tapering bond-buying this year. After briefly rising, 10-year yields dropped back.

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The problem is that we might be returning to an economic environment more such as the pre-2000s era, when the Fed was more concerned about inflation than about helping the economy. If we are, then rising bond yields would be a sign of economic news that is unhelpful to stocks (inflation) rather than a sign of news (a stronger economy) that is good for stocks.

Put another way, the more worried we are about inflation—or worse, stagflation—the more we should expect stocks and bond yields to move in opposite directions.