The Fed’s plan to taper economic support is just one of several hurdles for the bond market

Published Fri, Aug 20 20211:14 PM EDTUpdated Fri, Aug 20 20213:19 PM EDT

The Federal Reserve's plans to start exiting its easy-money programs this year poses potentially the most serious of several challenges the bond market faces ahead. With yields hanging around levels that would have been record lows prior to the pandemic, the central bank's indication that it will start curtailing its government bond purchases could be a significant factor challenging fixed income investors. The Fed's potential move, in which it could announce the tapering of quantitative easing in September and start the process as early as November, would require private investors to start absorbing more government debt in the form of Treasury issuance. Additionally, continued inflation pressures also threaten to push yields higher, as does the U.S. economic expansion and the expectation that the hiring pace will pick up even more in the fall. In the near term, bond yields have shown little reaction to the developments from the Fed. In fact, the benchmark 10-year Treasury yield has nudged lower since the release of minutes from the July Federal Open Market Committee meeting. The summary indicated that most members were comfortable with proceeding with tapering before the end of the year, a move that would gradually unwind the minimum $120 billion a month the Fed is buying. Yields move opposite price, so when yields rise investors lose out on capital appreciation. Tougher road ahead Economist Joe LaVorgna said that while the market isn't flinching now, the future could be different. "The problem for the bond market is the Fed, which bought a whopping 57% of all Treasury issuance in the last year ($1 trillion)," LaVorgna, the chief economist for the Americas and former head economist under the Trump administration, said in a note. "This goes away when the Fed begins to taper Treasury purchases. Bond bulls have been forewarned." Central to LaVorgna's thesis is the notion that the Treasury Department will need to step up its issuance to keep pace with the burgeoning government budget deficit. The red ink is expected to total some $3.7 trillion for fiscal 2021 before falling to $1.8 trillion in 2022 and a little shy of $1.4 trillion in 2023, according to the most-recent government projections. In addition to the Fed scooping up a large portion of government debt over the past year, Treasury has dipped into its general account to help fund the government, but there is just $435 billion left after peaking at $1.9 trillion a little over a year ago. For its part, Treasury has said its funding needs actually will decline in the months ahead. But LaVorgna thinks that's unlikely. "The Treasury cash balance can't go down anymore," he said in an interview subsequent to two notes he released this week on the topic. "Based on their projections, they have to increase supply." Deficit issues aside, there are other factors pressuring bonds. Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research, doesn't see tapering as a huge problem for the bond market but still expects yields to climb. Jones sees the 10-year yield heading up to as high as 1.75% this year – it was trading at 1.25% on Friday – but anticipates the driving factors to be economic growth rather than the mechanics of Fed purchases. "The need for somebody to absorb that issuance may not be as great as it has been recently," she said. "It's been a challenging year for trying to predict [the bond market], because it's been up, down and everywhere." One issue that could protect investors, and that accounts for the lack of movement in yields, has been that the Fed has gone to great lengths to ease the market into accepting that it will no longer be as accommodating as it's been. Even the minutes contained a number of cautionary phrases about the importance of remaining data-dependent. Some members said they'd still rather wait until early 2022 before tapering commences as they watch how economic progress unfolds. Still, the likelihood that yields will stay this low amid a growing economy and inflation more persistent than some Fed officials expected will be substantial challenges. "The Fed will be paying close attention to market functioning as it begins to dial back purchases," Bank of America rates strategist Meghan Swiber said in a note to clients. "Liquidity issues are still a risk because the Fed has been such a prominent buyer in the market, and as it exits more fully in '22, we see more potential for disruption." Become a smarter investor with CNBC Pro . Get stock picks, analyst calls, exclusive interviews and access to CNBC TV. Sign up to start a free trial today .

The U.S. Treasury building in Washington, D.C., on Friday, March 19, 2021.

Samuel Corum | Bloomberg | Getty Images

The Federal Reserve's plans to start exiting its easy-money programs this year poses potentially the most serious of several challenges the bond market faces ahead.