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Fed Tapering: Economic Recovery From The Pandemic

Looking back to the past 2021, the overall theme is recovery. With financial stimulus from governments across the world, liquidity was injected into the market. For example, for most of the past year and a half, the U.S. Federal Reserve has been buying at least $120 billion of bonds each month, providing unprecedented support to financial markets. Although COVID-19 hasn’t ended, the economy has recovered from its lowest point since the pandemic, which is indicated by macro deliverables such as climbing inflation and the fresh low unemployment rate. The timing for central banks to tighten their extra loose monetary policies may have come. 

At the September 22 meeting, the Federal Open Market Committee (FOMC) announced a formal tapering announcement was forthcoming on its monthly securities purchases if progress continues broadly as expected, indicating their intention to slowly pull back the stimulus they have provided during the pandemic. In light of the rate hikes, the Fed would leave the Fed Funds Target Rate (0-0.25%) unchanged for now but half of the committee members expected at least one rate hike by the end of 2022. 

What is tapering and why is now the right time?

Tapering refers to the process of the Fed scaling back its asset purchases (also called quantitative easing) when economic conditions improve and such stimulus is no longer required. During the pandemic, the bond purchases have added more than $4 trillion to the Fed’s balance sheet, which now stands at $8.5 trillion, about $7 trillion of which is the assets bought up through the Fed’s quantitative easing programs, according to the central bank’s data. The purchases have helped keep interest rates low, provided support to markets that malfunctioned badly at the start of the pandemic crisis, and coincided with a powerful run for the stock market.

One of the main reasons why the Fed is going to taper its bond-purchasing program is that the latest economic data highlights positive signs of recovery: last week’s labour market report shows the U.S. employment rate plummeted to 4.8%, a new pandemic low, and the jobless claims dropped to the lowest since March 2020, totalling 293,000. With the maximum employment being one of two Fed’s mandates, substantial progress in the labour market prompts the Fed to tighten its current extra loose monetary policy. 

Besides, the market expects a tighter monetary policy to tackle the current inflationary pressure, which is seemingly more resistant than the “transitory” inflation, as the Fed previously claimed. The Consumer Price Index rose by 0.4% in September, exceeding the median estimate of 0.3%, showing the economy is still grappling with decade-high price growth amid severe supply bottlenecks. The notable thing about September’s CPI report is that it showed the drivers of inflation are starting to broaden out from areas under reopening pressure such as transportation services and hotels. For example, car prices (+1.3% month-over-month) are being squeezed by the shortage of semiconductors, which are needed for automotive electronics. Also, stickier areas such as owners’ equivalent rent (+0.4%) picked up in September by more than what we saw at any point in the last cycle.

All these factors continue to point to a November taper announcement as revealed in the latest Fed minutes, with $15 billion of taper to begin shortly thereafter and to conclude by summer/early fall 2022. The Fed minutes also indicated that the central bank probably would start by cutting $10 billion a month in Treasury and $5 billion a month in mortgage-backed securities.

How does the market react to the upcoming Fed tapering?

Three weeks have passed since the last FOMC meeting, the market resumed its growing trend after fluctuations for a short period of time. Compared to the pre-FOMC level, S&P 500 has risen by 2.7% and the blue-chip Dow Jones has climbed 4% higher as it benefits from the value rotations driven by rising bond yields. In the aftermath of an immediate selloff, the 10-year Treasury yield, an important benchmark that guides other interest rates, has risen by 31 basis points to 1.62%. This means the Fed’s tapering intentions reflected a high level of confidence that the economy will continue to recover from the pandemic-induced recession, which boosted market optimism. 

Possible impacts of tapering on the market

In terms of bonds, UBS expects the 10-year US Treasury yield to reach 1.8% by the end of the year with the scaling back of the bond-purchasing program. 

The impact on the stock market is still indecisive. So far, declining rates brought by the Fed’s quantitative easing have certainly given a major boost to equities, as the S&P 500 has climbed more than 30% from a year ago. Now as rates begin to rise, valuations potentially come under pressure, and that is heightened by the fact that in recent years markets and portfolios have become concentrated in secular growth stocks that are particularly rate-sensitive, since their valuation depends heavily on future cash flows. That being said, it does not mean that equities will decline in absolute terms even if rates are rising. Goldman Sachs expects equities will continue to appreciate driven by earnings growth, alongside modestly higher yields.

On the currency front, analysts at TD Securities expect the tapering will help strengthen the dollar. The U.S. currency’s trajectory is important for investors as it impacts everything from commodity prices to corporate earnings. As higher yields make dollar-denominated assets more attractive to income-seeking investors, such increasing demand for the greenback will in turn boost the dollar index in the coming months.

Sources

https://www.citibank.co.uk/personal/market-insights.do?article=looking_through_market_noise_2022&ecid=EMNADUKPCBENUKCINSIGHTSL05

https://www.reuters.com/business/finance/investors-look-ahead-rate-hikes-with-fed-tapering-plan-all-certain-2021-09-23/

https://www.cnbc.com/2021/09/23/heres-what-will-happen-when-the-feds-tapering-starts-and-why-you-should-care.html

https://www.bloomberg.com/news/articles/2021-10-14/u-s-initial-jobless-claims-fall-to-fresh-pandemic-low

https://www.ft.com/content/410aab44-2e56-40e8-bf7c-e3aa942fc88c

https://www.bloomberg.com/news/articles/2021-10-14/u-s-initial-jobless-claims-fall-to-fresh-pandemic-low

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