In the summer 2021, several Federal leaders seemed to indicate that the eventual tapering off of an accommodative policy would start before the year ended. Basically, the Fed might start tapering off some of the bond purchasing it initiated in response to the Covid pandemic. That sounded like it could be good news, but when the Fed signaled it would slow stimulus after the Great Recession, the markets flew into what was called a “taper tantrum”. That doesn’t mean the markets will react the same way this time around, but understanding how the Fed stimulus works and what could happen when it ends, could help investors prepare their portfolios. First, it’s helpful to understand how we got here. When the world locked down in response to the Corona virus pandemic, the US economy got slammed pretty hard. The Fed slashed its target for interest rates and ramped up quantitative easing, or QE, seeking to shore up financial markets and stimulate the economy. 

QE is a tool used by central banks to provide liquidity to financial markets and keep money moving through the economy. Since July 2020, the Fed has been buying $80 Billions of treasuries and $40 Billions in mortgage backed securities every month. The goal is to lower yields. This makes borrowing for people and businesses cheaper, ideally boosting the economy. But, by March 2021, unemployment had floated back down to 6 percent from a high of almost 15 percent and inflation had ticked above 2 percent. The economic freeze seemed like it was starting to thaw. In August 2021, the Fed signaled it may be nearing the end of its QE program. The idea is that as the economy recovers, the Fed can stop buying assets, and interest rates should return to more normal levels. This giant buyer leaving the market leads to a drop in bond prices, pushing up interest rates. This hopefully keeps the economy from overheating and slows inflation from rising to unhealthy levels. But, the Fed doesn’t immediately stop buying assets. Instead, it gradually backs off QE in a process called tapering. Tapering is a part of the recovery process. It means the Fed feels the stimulus worked  and they can back off a little. Basically, it’s taking the foot of the gas but not yet pressing on the brake. The gradual reduction is supposed to avoid disrupting the financial markets. But it doesn’t work out like that when the Fed began tapering QE after the great recession. Back in May 2013, then Fed chairman, Ben Bernanke told congress the Fed could start slowing QE if the economy continued improving. But, that surprised the markets, leading to a spike in volatility. The S&P 500 dipped 6% after the announcement, although this was a short time dip, and it went on to close the year up around 30%. Over the four months after Bernanke’s congressional appearance, 10-year treasury yield rate jumped more than one percent point. In December 2013, the Fed started tapering asset purchases from $85 Billions down to $75 Billions. It continued reducing QE by $10 B a month. Despite the initial shock to the market, tapering had a relatively mild impact to overall economic growth for 2013, with economy still growing 26% for the year. This time around, as of August 2021, markets have barely reacted to the news that tapering may be coming. The Fed eager to avoid a repeat of the taper tantrum of 2013 by laying a lot of ground work publicly, so investors are not surprised when the tapering plan is announced. There is no way to know for sure how markets would react when tapering actually begins, but here are some things to look out for and ways to consider preparing. Like we mentioned, as the Fed incrementally steps out of the market, historically that has led to upward pressure on interest rates, particularly further out on the yield curve. 

If you hold bonds that have a 10-year or higher duration, you may see some higher volatility. If you suspect a taper tantrum is coming, you may be tempted to pull out of bonds altogether, but consider moving away from longer-dated bonds instead. This could help you avoid being locked into lower yields, should interest rates rise, you ‘ll likely want to be able to invest in those higher rates. It is not just the bond market that can be impacted by tapering either. The prospect of higher interest rates could dig into stock valuations. You may see stock volatility jump, but try to avoid making rash decisions. Defensive stocks like utilities and consumer staples may seem smart. But remember, Fed tapering coincides with a strengthening economy. So, small caps, international stocks and cyclicals like industrials and basic materials may benefit in this environment. But keep in mind that small-caps are subject to erratic market movements and may have lower trading volume than securities of larger cap stocks. And, international investments involve special risks, including currency fluctuations and political and economic stability. Since banks borrow on the shorter end and lend on the longer end of the yield curve, increasing rates are a boon to the financial sector as well. 

However, you decide to weather tapering, try to set a plan and stick to it. There may be some turbulence in the markets, but this could create some opportunities as long as the economic backdrop stays positive. With new Covid variants swirling around, this may be a moving target for quite sometime.

India Spending Forex Reserves to Defend Rupee with Prudence 

The Reserve Bank of India is once again seeking to defend its currency when the Fed is tightening. One economic and strategy head of a major bank says prudence warns against trying to defy broad-based dollar trends. After all, a $600 Billion plus reserve coffer is harder to build than it is to burn. The rupee slid to a record low of 77.53 per dollar on Monday as the greenback continued its rise and amid elevated crude prices, which is threatening to widen the trade deficit to unprecedented levels. 

India’s central bank is intervening in all foreign-exchange markets including the offshore markets and will continue to do so to protect the rupee that slid to a record low Monday, May 9, 2022.

Courtesy: TD Ameritrade