To Taper or Not to Taper

“To be, or not to be? That is the question: Whether tis’ nobler in the mind to suffer the slings and arrows of outrageous fortune, or to take arms against a sea of troubles…” – William Shakespeare, Hamlet

At the recent Jackson Hole policy summit, Chairman Jerome Powell said that the Fed would likely begin tapering (reducing) its bond buying later this year. This was not a revelatory statement by any means but rather an announcement that markets had been anticipating for quite some time. However, the mere notion that the Fed might gradually take its foot off the gas pedal created a bit of Hamlet-esque angst for investors. To taper or not to taper, that is the question.

What has the Fed been doing?

During the thick of the market sell-off in March 2020, the Fed started to buy bonds to support financial markets and to stimulate the economy. Known also as quantitative easing, this was not a new strategy for the Fed but rather a page from the old post-financial crisis playbook. Over the past eighteen months, the Fed has bought $120 billion of bonds ($80 billion in Treasuries and $40 billion in mortgage-backed securities) every month, expanding its balance sheet from $4.7 trillion to nearly $8 trillion.

What does it mean to taper, and why do it?

The Fed controls short-term interest rates by adjusting the Fed Funds rate. That rate currently sits right around 0%. In his recent statement, Chairman Powell reiterated that the Fed intends to keep short-term rates near 0% for some time to come. The Fed also can influence longer-term rates through quantitative easing (buying bonds). Lower long-term rates mean cheaper mortgages and lower borrowing costs for businesses.

If the Fed starts to taper, it will merely buy bonds at a slower pace until it ultimately stops buying bonds months if not years down the road. And, at some point, possibly way out in the future, the Fed may begin to reduce its balance sheet by letting the bonds it holds mature without replacing them with new bonds. Tapering is akin to a car gradually decelerating by one taking their foot slightly off the gas pedal. It does not mean one steps on the brake or stops the car entirely.

Should investors be nervous?

The short answer is no. Why? Because we have been here before. The Fed engaged in quantitative easing for several years following the financial crisis. It was not until mid-2013 that then Fed Chairman Ben Bernanke announced the Fed would taper later that year. At the time, the mere announcement sent bond markets into a tizzy – the so-called Taper Tantrum – mostly because it was unexpected. In this case, Chairman Powell only confirmed what markets have believed (and priced in) for some time. The Fed is by no means putting the brakes on the economy. And if history is any guide, markets (both bonds and stocks) will ultimately absorb this round of tapering much like they did when the Fed last began tapering in late-2013.

What about my bonds?

When the Fed begins tapering, longer-term interest rates may rise. Rising interest rates create a headwind for bonds. However, our bond strategy is built to absorb this, especially with the adjustments made recently and earlier this year. Those changes, combined with your bond portfolio’s shorter average duration (maturity) and its diversification of holdings, should provide a continued ability to navigate the bond market even as the Fed slightly shifts its course.