The Taper Tantrum as an Expectations Shock

The Taper Tantrum is a well-known event to any investor on Wall Street, taking place in 2013. As Christopher Leonard details in The Lords of Easy Money, it began at a Jackson Hole retreat where Federal Reserve Chairman Ben Bernanke signaled that the Fed would continue Quantitative Easing (QE). This created an expectation in the markets that there would be sustained demand for 10-year US Treasuries. The expectation grew because the "open-ended" program, designed as a flexible policy that would adjust its Long-Term Asset Purchases (LSAP), was interpreted as a commitment to large-scale buying. These renewed expectations caused the prices of stocks and bonds to rise, as the cost of capital decreased and the US dollar weakened. Some Fed governors opposed the continuation of QE, but their hands were now tied: reducing it would risk a significant market correction. However, these expectations became unanchored. Markets began expecting the Fed to acquire unreasonable amounts, upwards of $1 trillion in assets, when the original undisclosed Fed plan was to acquire only $500 billion. This forced the Fed into a decision: either double down and increase LSAP, or signal that QE would be more moderate.

To appease QE opponents, Bernanke agreed to publicly announce a tapering. He soft-pedaled the message, stating the Fed would likely reduce purchases if growth remained strong. Wall Street, however, heard only one thing: QE would be reduced, and sooner rather than later. This caused a market shock and a surge in volatility. Equity markets declined immediately, and the bond market faced a drastic repricing, with 10-year Treasury yields rising sharply. The reduced expectation of quantitative easing also strengthened the dollar and raised the cost of capital, reshaping the economic environment drastically.