Font size
Jerome Powell, Chairman of the Federal Reserve.
Susan Walsh-Pool / Getty Images
As the economy heats up, the Federal Reserve may begin to reduce the size of its bond buying program, removing a layer of support in the stock market.
In the December minutes of the Fed, released this week, members of the Federal Open Market Committee highlighted the recent strength of the economy, saying it “has shown resilience in the face of the pandemic.”
The economic recovery was largely V-shaped. Tax incentives are more than expected to keep consumers and small businesses afloat and willing to spend money and re-hire workers when the millions of expected doses of Covid-19 vaccines are distributed – although distribution is slow. If the economy really does recover as quickly as expected, the FOMC could indeed take its foot off the accelerator.
Some on Wall Street expect it.
Weeks after that
Citigroup
strategists and
Morgan Stanley
Economists have raised the possibility that the Fed will reduce the size of its program, Morgan Stanley economists wrote in a note Thursday that the possibility is getting closer to reality. Economist Ellen Zentner wrote that the Fed’s minutes mean that “we see the FOMC winding down its asset purchases from January 2022”.
The central bank buys $ 80 billion in treasury bills and $ 40 billion in mortgage bonds every month to keep bond prices high and interest rates low to stimulate economic activity. The Fed has made it clear that it would continue to do so for as long as the economy needs it.
But this is a sensitive issue for investors, not only because the Fed has not provided quantified guidelines as to when it will change its program, but also because of the memories of the “taper tantrum” of 2013. That was when the Fed narrowed its size. of the crisis-related buying program, pushing bond yields higher and putting the economy at risk. When the Fed hiked interest rates in late 2018, the
S&P 500
decreased by 16% in less than two months.
The Fed would likely shrink the size of its program before hitting short-term interest rates above the current 0% -0.25%, which probably won’t happen until 2023. Zentner, citing the Fed’s mention of the phasing out in 2013 and 2014, said it will likely cut the volume of purchases by about $ 10 billion in government bonds and $ 5 billion in mortgage bonds by 2022.
If the Fed buys fewer bonds, their prices would come under pressure. Rates, which change in reverse to prices, are likely to increase. Higher interest rates put pressure on equity valuations because they make the risk of being in equities less attractive to buying safe Treasury bills.
Valuations are currently incredibly high historically due to low interest rates, but if the higher interest rate dynamics materialize, it likely indicates a strengthening economy, indicating rising earnings outweighing declining valuations.
Just don’t buy stocks if the Fed starts to ease too quickly.
Write to Jacob Sonenshine at [email protected]