There is no shortage of Fed watchers who carefully comb through official press releases, FOMC minutes, and transcripts for even the slightest changes in language and intentions for monetary policy.

The Fed has indicated to these observers and the market more broadly that it intends to taper in the coming months.

“Fed tapering” refers to the Federal Reserve’s decision to, at the very least, purchase fewer government bonds each month than it had previously.

After the 2008 financial crisis and during the COVID-19 pandemic, the Federal Reserve started purchasing US treasury bonds (highlighted with red arrows in the chart below) to show the market that there is always a buyer of last resort to support the financial system. After the initial surge in large asset purchases, the Federal Reserve continued to purchase smaller amounts over time.

These actions are intended to give peace of mind to market participants who are willing to buy risky assets such as stocks or real estate.

CNBC adds context by stating, “For most of the past year and a half, it has been buying at least $120 billion of bonds each month, providing unprecedented support to financial markets and the economy that it now will start to walk back. The bond purchases have added more than $4 trillion to the Fed’s balance sheet, which now stands at $8.5 trillion…”

Charles Schwab is even more explicit with its definition of what Fed tapering means:

“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 outright sale of Treasuries or Agency mortgage-backed securities by the Fed is known as Quantitative Tightening or QT for short. This could be the Fed’s next policy action if its move to taper is successful. We will leave the discussion of QT for another day.

Sources:
CNBC, September 2021. “Here’s what will happen when the Fed’s ‘tapering’ starts, and why you should care”
Charles Schwab, August 2021. “Fed Tapering: Will It Be Different This Time?”

While the future is uncertain, experts believe that even a minor form of Fed tapering will likely mean the balance sheet will increase at a slower rate going forward. This means less issuance of new bonds by the Treasury department will be absorbed by the Federal Reserve and will need to be bought by the market.

Paul Gruenwald, global chief economist with S&P Global Ratings, recently stated, “By holding these large bond portfolios [the Fed] is pushing down yields, pushing up asset prices by implication, pushing down spreads and reducing credit discipline…"

If holding and adding these assets to the Fed’s balance sheet contributes to higher valuations, then reducing future increases to the size of the balance sheet would lower valuations, a fairly bearish view from an S&P economist.

Ray Dalio stated, “Large government deficits exist and will almost certainly increase substantially, which will require huge amounts of more debt to be sold by governments — amounts that cannot naturally be absorbed without driving up interest rates at a time when an interest rate rise would be devastating for markets and economies because the world is so leveraged long."

In fact, the IMF newly published Fiscal Monitor stated that the world is in $226 trillion of debt.

So, there is a compelling case to be made that a Fed Taper is bearish for markets. See the flow chart from Nordea, the Scandinavian bank.

Their view is that when the Fed eases, money moves to riskier assets. When the Fed tightens policy, money moves to less risky assets. Tapering sits in the middle of these two policy decisions.

So tapering can be viewed as bearish in the sense that it is less supportive of higher valuations in the stock market. But Fed tapering does not necessarily indicate that the market will suddenly move lower either.

In 2013, Treasury yields rose abruptly after the Fed announced it would reduce its bond purchases. Having just come out of the Global Financial Crisis, tapering was an action that no policymakers at the Fed had ever taken before in their careers. The Fed lurched back into action and announced new bond purchases at the first sign of stress in the market.

The Federal Reserve is hoping that it will be unnecessary to jump in and support the market so quickly. That’s why the Fed has been bracing the market for months after numerous policy-making gatherings.

Yahoo! News notes that the Fed has been extremely careful with its messaging. The Fed chose to warm the market up to tapering the balance sheet by saying that the central bank was “‘talking about talking about’ changing this program.”

The act of Tapering can be seen as a vindication of the historic policy actions that the Fed has taken to ensure a stable economic recovery after the global shutdowns induced by COVID-19. The act of Tapering may show that the economy is stable enough to normalize U.S. monetary policy. However, the Fed will be watching how global markets and economies absorb and react to this closely watched change in policy. Fed policymakers will be on notice due to the headline-grabbing market volatility of 2013 which was dubbed the Taper-Tantrum at the time.

Sources:
S&P Global, August 2021. “Economists warn of market disruption as Fed balance sheet surpasses $8 trillion”
Forbes, October 2020. “Can The Federal Reserve Print Money Forever? Or, How Continuing To Print Money To Support Deficit Spending May End Badly, With China’s Help”
IMF, October 2021. “Fiscal Monitor, October 2021: Strengthening the Credibility of Public Finances”
Nordea, August 2021. “FX weekly: What’s bad for Biden is good for the USD”
Yahoo, June 2021. “The Fed won’t talk about talking anymore.”
Investopedia, October 2020. “Taper Tantrum”

In our piece, “FedSpeak: Breaking Down Past & Present Fed Policy”, we explained that the Federal Reserve’s two main policy goals are stable prices and maximum employment.

Inflation is currently roaring and at its highest level in over a decade. Data shows that consumers are still spending and employment numbers have largely recovered. In fact, the latest employment report stated that the unemployment ticked below 5% this past month, with the unemployment rate improving to 4.8% from 5.2%.

Bearish commentators will say that the Fed is being forced to Taper because of inflation fears. Going further, former Republican Congressman Ron Paul is steadfast in his view that bond purchases by the Federal Reserve cause market bubbles.

More bullish commentators will point out that employment and financial markets are quite strong. Derek Thompson of The Atlantic writes, “In April, the number of workers who quit their job in a single month broke an all-time U.S. record. Economists called it the “Great Resignation.” But America’s quittin’ spirit was just getting started. In July, even more people left their job. In August, quitters set yet another record.”

The ability for workers to quit indicates higher confidence in the ability of laborers to find new work for better wages. This phenomenon is certainly a welcome development for these workers but could portend higher inflation if employers successfully raise prices to offset these higher labor costs.

The Fed’s two main goals of maximum employment and stable prices are at odds with each other in this way.

Ultimately, regardless of the Federal Reserve’s true motivation for tapering its bond purchases, they have signaled that they plan to change their bond-buying policy.

Bulls will mention strong consumer demand, Bears will mention inflation.

The Fed has said they will taper.

Sources:
Bureau of Labor Statistics, THE EMPLOYMENT SITUATION — SEPTEMBER 2021.
The Atlantic, October 2021. “The Great Resignation Is Accelerating”
CNBC, July 2018. “This is the 'biggest bubble in the history of mankind and it's going to burst,' Ron Paul says”

In the face of a global crisis, the Federal Reserve implemented an extremely accommodative monetary policy. Now, with global economies recovering, monetary policy is set to normalize. The first major change from the Federal Reserve is to taper their purchases of Treasury and Mortgage securities.

In June the Wall Street Journal wrote, “When Federal Reserve officials started talking about pulling back on the central bank’s easy-money policies back in 2013, anxious investors sent markets into a tizzy. Yields on Treasury bonds rose, emerging-markets stocks tumbled, junk bond prices fell and stock volatility jumped, all in what came to be known as a market ‘taper tantrum’ which preoccupied the Fed for months and played a role in delaying its plans.”

The opposite is happening now: The Fed signaled it has begun discussions of reducing bond-purchase programs launched during the Covid-19 pandemic, and investors are placid.”

Markets have continued to march higher in the face of the Fed’s policy guidance.

How the market reacts to the Fed’s actual implementation of tapering remains to be seen. At the very least economists, researchers, and investors take the view that tapering is incrementally less bullish than continued asset purchases by the Fed.

Bulls will argue the Fed tapering is occurring because of a robust economic recovery. Bears will say it’s because inflation is rearing its ugly head.

Whatever the reasoning behind the Fed’s decision to Taper, the market and the Fed will be watching each other quite closely as it moves to implement this policy shift.

Source: Wall Street Journal, June 2021. “Why There Is No ‘Taper Tantrum’ This Time Around”