Here’s what will happen when the Fed’s “tapering off” starts and why you should care

Here's what will happen when the Fed's

Mariner S. in Washington Eccles Federal Reserve Building.

Stephanie Reynolds / Bloomberg via Getty Images

Presumably before the end of the year, the Federal Reserve will begin to delve into the unknown.

Central bank officials said on Wednesday they were ready to begin “dilution” – the process of phasing out incentives provided during the pandemic.

While the Fed has already made political withdrawals, it has not had to back down from such a spectacularly accommodating stance. For the past year and a half, it has been buying bonds worth at least $ 120 billion every month, providing unprecedented support to financial markets and the economy now that it will start to retreat.

Bond purchases added more than $ 4 trillion to the Fed’s balance sheet, which now stands at $ 8.5 trillion, central bank data shows, including around $ 7 trillion in assets purchased as part of the Fed’s quantitative easing programs. The buyout helped keep interest rates low, provided support to markets that were hit hard at the onset of the pandemic crisis, and coincided with a powerful stock market run.

In light of the role of the program, Fed Chairman Jerome Powell assured the public on Wednesday that “policy will remain lenient until we meet the central bank’s jobs and inflation targets. “.

The market has taken this news well so far, but the real test lies ahead. Tapering represents future rate hikes, although they appear to be at least a year away.

“It’s certainly communicated well, so I don’t think it should shock anyone or disrupt the market,” said Cathy Jones, head of fixed income at Charles Schwab. “The question is really more around real estate prices. [interest] rates. We have very high valuations across asset prices. What changes in real estate prices compared to the very easy money? “

The answer so far is… nothing. Despite a prior announcement of a Fed tapering, the market rallied on Wednesday afternoon and rebounded on Thursday.

How the rest plays out depends on how the Fed is phasing out its ticket printing operations.

How it works

This is what the recording might look like:

Powell said a formal registration decision could be made at the November meeting and the process would begin shortly thereafter. He said he believed the recording would end “in the middle of next year”. This timeline then offers a view of how the actual cut will be cut short.

If the reduction does begin in December, reducing purchases to $ 15 billion per month would reduce the process to zero in eight months, or July.

Jones said she would expect the Fed to cut $ 10 billion a month in treasury bills and $ 5 billion in mortgage-backed securities. There have been calls within the Fed to be more aggressive with mortgages given the high housing prices, but this does not appear to be the case.

Federal Reserve Chairman Jerome Powell testifies during a US House Oversight and Reform Select subcommittee hearing on the coronavirus crisis on June 22, 2021 in Capitol Hill, Washington.

Graeme Jennings | swimming pool | Reuters

At the press conference following that meeting, Powell’s general tone took Jones by surprise. The President has repeatedly stated that he is satisfied with the progress made towards full employment and price stability. With inflation well beyond the comfort zone of the Fed, said Powell, “this part of the test has been completed, in my opinion, and in the opinion of many others.”

“As far as the recording went, the tone was probably a little louder than the market expected,” Schwab’s Jones said. “The comment that the Fed will end by the middle of next year was like, ‘Well, if we’re going to do that, we better take a step here.’”

Jones said Powell’s comments and the Fed’s slim intentions reflected a high degree of confidence that the economy will continue to recover from the pandemic-induced recession, which was both the shorter and the longer. fastest in US history.

“The Fed tells us that it collectively expects growth and inflation to be strong enough next year, and it is ready to reverse the easing policy,” she said.

A view of rising rates

What happens after the cone is really important.

A summary of individual members’ rate forecasts – the haunting dot plot – indicates a slightly more aggressive posture. The 18-member Federal Open Market Committee responsible for policy development are divided over whether to implement the first quarter-point hike next year.

Authorities are forecasting three more hikes in 2023 and 2024, taking the Fed’s key rate to between 1.75% and 2%, from its current 0 to 0.25%. Powell stressed that the Fed will proceed with caution before raising rates and will likely wait until the cut is complete, but the market will watch for further bullish signals.

“The next Fed meeting could be really interesting. This should give us a lot more volatility than today, ”said John Farwell, chief trader at Roosevelt & Cross bond underwriters. “They made even stranger sounds. It will be data driven and will be about how Covid plays out, ”he said.

For investors, it will be a new world in which the Fed is still supporting it, but not as much as before. While the mechanics seem simple, things can get complicated if inflation continues to exceed the Fed’s expectations.

FOMC members raised their key inflation forecast for 2021 to 3.7%, from 3% in June. But there are plenty of reasons to believe the predictions are quite the opposite.

For example, in recent days, leading companies in the economy, including General Mills and Federal Express, have indicated that prices are likely to rise. Natural gas has grown by over 80% this year, which would mean energy costs would be considerably higher during the winter months.

UBS expects economic conditions and easing news to begin to put upward pressure on yields, pushing the benchmark 10-year Treasury index to 1.8% by the end of 2021. C ‘ is around 40 basis points from its current level, but “is not expected to have a significant negative impact on borrowing costs for businesses or individuals,” UBS said in a note to clients.

Yields move in the opposite direction, meaning investors will sell bonds in anticipation of higher rates and less support from the Fed.

UBS analysts say investors should keep in mind that the Fed is moving forward as it has more confidence in the economy and will continue to provide support.

“As higher bond yields reduce the relative attractiveness of stocks, the gradual increase in bond yields should more than offset the positive impact of rising profits as economies return to normal,” the company said. . “So tapering should be seen as a gradual return to emergency relief as the situation returns to normal.”

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