What Happens If The Federal Reserve ‘Tapers’ Its Support?

As kids go back to school and the temperatures turn cooler, it’s possible that the financial news headlines will heat up.

Case in point: The Federal Reserve. A lot of stock market participants, economists and pundits will spill a ton of virtual ink over the subject of “tapering” of bond market support and its effect on stock prices.

It’s difficult, if not impossible, to forecast any kind of outcome regarding such an event, but it might be helpful for long-term investors to at least understand the terms of the discussion.

Context can help you better manage the emotional reactions that can come with increased market volatility, always a possibility once the Fed starts swinging around its considerable weight.

So, what is tapering?

Photo: UM Ford School

Simply put, it’s the slow withdrawal of Federal Reserve bond purchases that have been in place for some time.

Remember, the market for U.S. Treasury bonds is global and quite deep. Foreign governments and buyers, domestic investors, institutions, banks and companies all rely on a steady supply of bonds to hold what amounts to trillions in cash.

They do this because U.S. government debt has long been seen as “risk free” when compared to, say, stocks or other investments. While that’s debatable, U.S. bonds are certainly lower risk than many other forms of debt, either private or issued by other governments.

If bonds are so great, why has the Fed been buying them in the first place? The short version is that the Fed has long targeted a very low benchmark interest rate — virtually zero.

Since the bond market is a free market, one way to force rates lower is to buy up bonds in excess of demand from private buyers.

“Tapering” refers to a slow and steady withdrawal of that buying power in favor of letting the market determine interest rates. That would, in theory, lead to a rise in the interest rate over time.

What’s unknown is whether or not the U.S. economy is in a place to handle a higher benchmark interest rate. All other lending — mortgages, car loans, business borrowing, credit cards and so on — consider the benchmark, the federal funds rate, as a baseline.

If that baseline moves higher, so does the cost of borrowing money across the economy and around the world.

The Fed may have good reason to let the interest rate rise. It could be that the domestic economy is growing too fast. That could lead to inflation, which is hard to manage without dramatic steps.

Taper tantrum

The worst-case scenario is rapidly rising and long-lasting inflation which leads the Fed to quickly raise the interest rate. That could damage stock valuations in the short term, as well as having the slower if salutary effect of slowing the economy in order to rein in inflation.

Will stocks fall if the Fed decides to taper? No one knows, not even the Fed. But even chatter about tapering can have an impact.

Back in 2013, then Fed Chairman Ben Bernanke talked about reducing Fed support in the future and that alone sent Treasury yields upward (and bond prices, naturally, the other direction).

Importantly, stocks did not follow suit. Yet that may have been for a number of reasons, including near-immediate moves by the Fed to soften the reaction through policy cues designed to assure bond investors.

Nevertheless, tapering is likely to be back in the news over the next few weeks, and it’s likely that some financial advisors will bring it up in conversation with clients.

The key is to understand the history, control your own emotions and, if needed, review your tolerance for market volatility.

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