Here Comes Tapering; What Investors Need to Know
Last week the Federal Reserve released the minutes of its July 27-28 Federal Open Market Committee meeting. The headline takeaway was that the Fed is preparing for tapering later this year.
There is a well-known axiom in the investing world that says “Don’t fight the Fed.” What does this mean, and how does it relate to tapering? Let’s review.
In March 2020, as the COVID-19 pandemic began to tank the economy, the Fed cut the federal funds rate to nearly zero from 1.75% and it embarked on a major purchasing program of Treasuries and mortgage-backed securities (MBS). The rate cut and asset purchases were designed to stimulate the economy. This process is called quantitative easing (QE).
As an investor in March 2020, you may have had a grim outlook for the next year. And you would have been right. COVID-19 threw the markets for a loop, dropping the S&P 500 by 30% in just a few weeks.
Don’t ignore history…
However, the Fed’s actions helped to end the COVID-induced recession in record time. If you put your money on the sidelines during this time, you “fought the Fed” by ignoring the historical examples of what happens when the Fed injects massive stimulus into the economy.
The stock market recovered rapidly from the lows of March 2020. The economy is recovering strongly; in fact in some cases too strongly. Although job creation and gross domestic product (GDP) growth over the past few months have been higher than they have been in years, inflation is also rising.
There’s an important distinction between tapering and the end of QE. Tapering is the gradual winding down of the Fed’s bond purchases, not the end of those purchases. Core inflation is currently at 3.0%, higher than the 2.0% target of the Fed. Unemployment levels are still high, though. So the Fed has a challenging balancing act of keeping inflation in check while continuing to work down the unemployment numbers.
The Fed signals these sorts of moves early to minimize the impact on the markets. Nevertheless, shortly after the minutes were released, the Dow Jones Industrial Average turned down more than 150 points.
To further minimize the overall impact on the economy, the Fed also stressed that there are no plans yet to raise interest rates. The reason given was that employment has not met the “substantial further progress” benchmark the Fed has set before it would consider raising rates.
What can investors expect? In 2014, the Federal Reserve tapered for the first time. It was carried out over the course of 10 months by decreasing monthly purchases by $5 billion per month for Treasuries and MBS each. The performance in the markets was definitely impacted. In 2013, the S&P 500 returned 32.4%. In 2014 that return fell to 13.7%, and then in 2015 it was only 1.4%.
Returns were stronger in the years before tapering than in the years immediately after, but some sectors fared better than others. Real estate and utilities outperformed the markets during and immediately after 2014 tapering.
It pays to pay attention to what the Fed is doing. Take a lesson from history and position yourself accordingly. Don’t fight the Fed.
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