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Fed Tapering: What Is It, and Should Investors Prepare for a Taper Tantrum? - YouTube
Channel: TD Ameritrade
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In summer 2021, several Federal Reserve leaders
seemed to indicate the eventual tapering of
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accommodative policy would start before the
year ended. Basically, the Fed might start
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tapering off some of the bond purchasing
it initiated in response to the COVID pandemic.
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That sounds like it could be good news, but
when the Fed signaled it would slow stimulus
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after the Great Recession, the markets flew
into what was called a taper tantrum.
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That doesn鈥檛 mean the markets will react
the same way this time around, but understanding
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how the Fed stimulus works and what could
happen when it ends could help investors prepare
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their portfolios.
First, it鈥檚 helpful to understand how we
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got here. When the world locked down in response
to the coronavirus pandemic, the U.S. economy
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got slammed pretty hard. The Fed slashed its
target for interest rates and ramped up quantitative
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easing, or QE, seeking to shore up financial
markets and stimulate the economy.
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QE is a tool used by central banks to provide
liquidity to financial markets and keep money
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moving through the economy. Since July 2020,
the Fed has been buying $80 billion of treasuries
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and $40 billion in mortgage backed securities
*every month*. The goal is to lower yields.
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This makes borrowing for people and businesses
cheaper, ideally boosting the economy.
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But by March 2021, unemployment had floated
back down to 6 percent from a high of almost
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15 percent, and inflation had ticked above
2 percent. The economic freeze seemed like
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it was starting to thaw. In August 2021, the
Fed signaled it may be nearing the end of
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its QE program.
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The idea is that as the economy recovers,
the Fed can stop buying assets, and interest
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rates should return to more normal levels.
This giant buyer leaving the market leads
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to a drop in bond prices, pushing up interest
rates. This hopefully keeps the economy from
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overheating and slows inflation from rising
to unhealthy levels.
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But the Fed doesn鈥檛 immediately stop buying
assets. Instead, it gradually backs off QE
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in a process called tapering. Tapering is
part of the recovery process. It means the
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Fed feels the stimulus worked and they can
back off a little. Basically, it鈥檚 taking
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the foot off the gas but not yet pressing
on the brake.
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The gradual reduction is supposed to avoid
disrupting financial markets. But it didn鈥檛
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work out like that when the Fed began tapering
QE after the Great Recession. Back in May
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2013, then Fed chairman Ben Bernanke told
Congress the Fed could start slowing QE if
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the economy continued improving, but that
surprised the markets, leading to a spike
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in volatility.
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The S&P 500 dipped 6% after the announcement,
although this was a short-term dip, and it
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went on to close the year up around 30%.
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Over the four months after Bernanke鈥檚 congressional
appearance, 10-year treasury yield rates jumped
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more than one percentage point. In December
2013, the Fed started tapering asset purchases
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from $85 billion down to $75 billion. It continued
reducing QE by $10B per month. Despite the
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initial shock to the market, tapering had
a relatively mild impact to overall economic
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growth for 2013, with the economy still growing
2.6 percent for the year.
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This time around, as of August 2021, markets
have barely reacted to the news that tapering
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may be coming. The Fed is eager to avoid a
repeat of the taper tantrum of 2013 by laying
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a lot of groundwork publicly, so investors
aren鈥檛 surprised when the tapering plan
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is announced. There鈥檚 no way to know for
sure how markets could react when tapering
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actually begins, but here are some things
to look out for and ways to consider preparing.
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Like we mentioned, as the Fed incrementally
steps out of the market, historically that
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has led to upward pressure on interest rates,
particularly further out on the yield curve.
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If you hold bonds that have a 10-year or higher
duration, you may see some higher volatility.
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If you suspect a taper tantrum is coming,
you may be tempted to pull out of bonds altogether,
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but consider moving away from longer-dated
bonds instead. This could help you avoid being
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locked into lower yields. Should interest
rates rise, you鈥檒l likely want to be able
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to invest in those higher rates.
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It鈥檚 not just the bond market that can be
impacted by tapering either. The prospect
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of higher interest rates could dig into stock
valuations. You may see stock volatility jump,
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but try to avoid making rash decisions. Defensive
stocks like utilities and consumer staples
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may seem smart. But remember, Fed tapering
coincides with a strengthening economy. So
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small-caps, international stocks and cyclicals like
industrials and basic materials may benefit
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in this environment. But keep in mind that
Small-caps are subject to erratic market movements
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and may have lower trading volume than securities
of larger-cap stocks. And international investments
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involve special risks, including currency
fluctuations and political and economic instability.
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Since banks borrow on the shorter end and
lend on the longer end of the yield curve,
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increasing rates are a boon to the financial
sector as well.
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However you decide to weather tapering, try
to set a plan and stick to it. There may be
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some turbulence in the markets, but this could
create some opportunities as long as the economic
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backdrop stays positive. With new COVID variants
swirling around, this may be a moving target
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for quite some time.
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