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Fed tapering and tightening - what does this mean and how will the markets react?

By Hermione Taylor

13:00, 29 September 2021

Fed tapering
Source: Shutterstock

What did the Fed announce last week? 

The short answer is nothing – yet. In last week’s Federal Open Market Committee (FOMC) meeting, the Federal Reserve (The Fed) announced that it would not adjust asset purchases and interest rates.

Though the Fed wasn’t ready to slow its bond purchases, minutes revealed that “so long as the recovery remains on track, a gradual tapering that concludes around the middle of next year is likely to be appropriate” - a steeper withdrawal of support than many market-watchers were anticipating. 

The Fed also released projections for future interest rate rises and clarified the conditions that would need to be met before the FOMC raises rates. Half of rate setters now anticipate that interest rates will start rising next year, a move described by Lydia Boussour, lead US Economist at Oxford Economics, in a note to clients, as revealing “earlier and faster expected tightening of monetary policy” than previously indicated. 

building of US Federal Reserve?

What is Fed tapering?

When the Covid-19 pandemic struck last year, the Fed used asset purchases to preserve financial stability and support the economy as entire industries faced restrictions. 

These asset purchases are often referred to as quantitative easing (QE). Simply put, this is a mechanism whereby central banks purchase bonds. This tends to increase bond prices, reducing the bond yield (‘interest rate’) that bond holders get, feeding through to lower interest rates elsewhere in the economy. QE is a tool for supporting economies when interest rates are already very low, as they are in many developed economies

In last week’s announcement, the Fed credited asset purchases with restoring market function and supporting aggregate demand, but stressed that they were only ever designed as a temporary measure. 

When the Fed begins to taper, it will roll back the pace of its bond buying programme (currently sitting at $120bn a month), aiming to withdraw it entirely by the middle of next year. Last week’s meeting suggested tapering may soon be warranted, and Boussour said they “expect policymakers to formally announce tapering plans at the November policy meeting, assuming job creation reaccelerates in September and a debt ceiling crisis is averted”. 

What is policy tightening?

Tightening refers to increasing interest rates to stop an economy overheating. Last week’s meeting suggested that we could see a hike sooner than expected – half the FOMC membership are now anticipating a rate rise next year.

US Federal Reserve dot plot chart showing interest rate hike projections

Data, not dates

It’s worth noting that the Fed is taking a ‘data not dates’ approach to potential tightening and tapering. The Fed reiterated that it seeks to achieve maximum employment and long-term inflation at 2%, and that any policy would continue to support the recovery until it’s satisfied that this has been achieved. 

The FOMC also stressed that it would monitor public health, labour market conditions, inflation expectations and international developments - adjusting its stance in light of this. This means there is still a high degree of uncertainty around the timing and magnitude of any policy changes. 

“A weak uptake of booster vaccination shots or another, nastier variant, could derail this reflation trade and cause the Fed to delay hiking rates next year,” said Kathleen Brooks, founder and market analyst at Minerva Analysis.

US Federal Reserve chart shows uncertainty in projections of the federal funds rate

Effects of Fed tapering on the stock market

The term ‘tapering’ was first coined in 2013, when the Fed began to withdraw the support it had introduced in the wake of the financial crisis. Markets were caught off guard by the announcement, leading to the so-called 2013 ‘Taper Tantrum’, which saw yields on US treasuries shoot up as investors sold off bonds. 

Stock prices also showed more volatility after the announcement, as investors feared sell-offs, but this was relatively short lived.

S&P 500 following ‘Taper Tantrum’ in 2013

So what does Fed tapering mean for the stock market in 2021 and will we see another Taper Tantrum?

When central banks embark on asset purchase programmes, they buy from institutional investors, leaving them, in simple terms, with more cash. They often use this to purchase other financial assets such as stocks, meaning that QE tends to push up the value of shares.

A tapering announcement can therefore impact the stock market in two ways: by directly reducing demand for assets, like shares; and by signalling that the Fed is looking to wind down its stimulus package, meaning that rate hikes may also follow. 

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There was a relatively muted reaction to the Fed’s announcement last week, with the S&P 500 rallying slightly. However, unprecedented global conditions make it hard to unpick the specific impacts of future tapering as there is simply so much going on in the markets. 

“Out of control inflation and supply chain crunches could hurt all stocks, so value stocks may not go up in a straight line from here,” said Brooks. 

How do markets react to tightening? 

In theory, higher interest rates should affect the stock market, by making interest rate instruments relatively more attractive than shares. However, this relationship is far from clear cut. 

Analysis by S&P found that since the 1950s, rising rates have typically been bad for the stock market, with rate increases leading to a fall in the S&P 500. But a focus on post-1997 data reveals a different pattern: the months where interest rates fell were actually bad for the stock market. 

This led analysts to conclude that interest rates and stock prices today may well be driven by the same exogenous variables. In simple terms, a strong recovery could both herald a booming stock market and spur the Fed to increase rates.

Brooks echoed this, telling that the fact that the Fed is optimistic enough to consider hiking rates in the current climate could represent good news for growth sensitive stocks. 

Growth vs value stocks

It also looks likely that growth stocks and value stocks will also fare differently in response to a policy change.

The value of many tech stocks, for example, hinge on future earnings projections. These projections are calculated by estimating the value of future cash flows and discounting them by an interest rate – the higher the interest rate, the lower the value we attribute to future earnings.  

“When rates rise, future cash flows go down, which means lower stock price valuations and potential selling pressure,” Brooks told 

“In contrast, value stocks see their stock prices rise at this stage of the interest rate cycle, when rates are just being considered to be lifted after years at record low levels.”

Looking ahead 

Central banks elsewhere are also grappling with how and when to withdraw support. The Bank of England’s Monetary Policy Committee met last week, and elected to leave its interest rate and asset purchase policies unchanged.

Norges Bank, on the other hand, unanimously decided to raise the policy rate from zero to 0.25% thanks to “a normalising economy”. Will the Fed follow suit and announce a withdrawal of stimulus next time the FOMC meets in November? 

The risk of a policy misstep weighs heavily. The October jobs report will be released just days after the November meeting, which may leave the Fed wary of announcing tapering just as weaker job figures could be announced. 

Brooks noted that there could be a revaluation of the market if traders start to wonder if the Fed will make a policy mistake, especially if economic growth and inflation figures look weaker towards the end of the year.

Edited by Jekaterina Drozdovica


What does Fed tapering do?

When the Covid-19 pandemic hit at the start of last year, the Fed used asset purchases to support the economy. When it begins to taper, it will roll back the pace of bond buying, aiming to withdraw the QE programme entirely by the middle of next year.

How Fed tapering affects stocks

Growth stocks may well bear the brunt of the impact, according to Kathleen Brooks from Minerva Analysis. However, unprecedented global conditions make it hard to unpick the specific impacts of future tapering as there is simply so much going on in the market.

When did the Fed start tapering?

The short answer is not yet for this cycle of QE - though last week’s announcement indicated that a new round of tapering could start soon and conclude by the middle of next year. The Fed first tapered in 2013, when it began to draw back the support put in place following the financial crisis.

Read more: Market Close: China’s property sector, Fed tapering send shares down

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