EDITOR NOTE: The Fed has been purchasing massive amounts of Treasuries and agency mortgage-backed securities (MBS) since the pandemic hit the U.S. in March 2020. This economic manipulation has helped keep markets artificially high and investor confidence even higher. Now, the Fed announced that they will start tapering soon, reducing their Treasury and agency MBS purchases to zero. The Central Bank didn't share when it would start making these moves, but the announcement alone caused a historic dip in 10-year Treasury yields. Whenever the Fed actually starts tapering, it could have disastrous consequences in the markets. Investors have been pursuing risky investments that have been consistently paying off since the Fed started quantitative easing over a year ago. Now, this era of unending profits is over, and a major “uptick in volatility” in the markets is on its way.
As the Federal Reserve transitions from merely talking about tapering its bond holdings to actually tapering, investors may be left wondering what it might mean for the markets and their portfolios. Here’s a quick review of the Fed’s policies, what happened the last time the Fed tapered, and whether it will be different this time.
How we got here
In March 2020, the Federal Reserve was staring down the runway of an unprecedented pandemic with dire economic implications. As a result, the Fed quickly cut the federal funds rate to the range of zero to 0.25% from 1.5% to 1.75% and started purchasing large amounts of Treasuries and agency mortgage-backed securities (MBS) to provide additional stimulus to the economy above and beyond the rate cuts. These large-scale asset purchases are what is commonly referred to as quantitative easing (QE). The goals of quantitative easing are to:
- Support the smooth functioning of the financial markets
- Provide additional stimulus to the economy by lowering borrowing costs
- Put downward pressure on long-term yields to boost investment
- Support the MBS and commercial mortgage-backed securities (CMBS) markets through lowering interest rates for residential and commercial mortgages.
Fast forward through the shortest recession on record and the economy is rebounding strongly. The Fed’s economic forecasts for the end of 2021 show economic growth rising at a 7.0% pace, core inflation at 3.0%, and an unemployment rate of 4.5%.
Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents
Notes: For each period, the median is the middle projection when the projections are arranged from lowest to highest. When the number of projections is even, the median is the average of the two middle projections. The central tendency excludes the three highest and three lowest projections for each variable in each year. The range for a variable in a given year includes all participants' projections, from lowest to highest, for that variable in that year. Longer-run projections for core PCE are not collected.
As the economic picture improves, it is not surprising that the Fed would start talking about scaling back its stimulus. Although it’s waiting for “substantial further progress” towards its dual mandate of an average inflation target of 2% and full employment, it looks like those benchmarks may be reached sooner rather than later, given its forecasts for 2021.
What is tapering?
Tapering is a term used to describe the process of gradually stopping asset purchases when there is no predefined end date or amount. Tapering does not involve the outright sale of Treasuries or agency MBS by the Fed—it only means reducing purchases to zero. The Fed likes to signal its intentions around tapering its QE program well in advance to minimize the impact on the markets. Although in the past, the prospect of tapering has unsettled markets, we expect it to be more orderly this time around, as the markets have been through the experience before. Nonetheless, it’s important for investors to understand the process.
Now and then: The Fed’s balance sheet
The Federal Reserve initially implemented what some coined as “unlimited QE” in March 2020 before subsequently capping its monthly purchases at $80 billion and $40 billion for Treasuries and agency MBS, respectively. Ringing in around $7.7 trillion, the Fed’s current holdings of securities quickly blew past the prior peak seen after the 2007-2009 Great Recession. But that’s not the full story.
The Fed’s balance sheet has grown and changed
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