Contributing Writer at Tally
September 17, 2021
When the U.S. enters any recession, there are financial steps the government can take to rescue certain industries. From bailouts to stimulus checks, the options are plentiful. One such option is buying bonds and mortgage-backed securities to prevent a stock market free-fall.
That’s precisely what the Federal Reserve did as the COVID-19 pandemic struck. For the most part, it was a successful strategy that resulted in surges in the housing and automotive markets, as cheap credit flooded the market.
With the market stable, unemployment falling and the economy looking strong, we see the bad side of this process: severe inflation and supply chain shortages.
This is when bond tapering comes in — to slow demand without causing a market free-fall.
But what is bond tapering, and how will it impact you? Let’s explore this financial tool and see what’s in store.
Bond tapering is when the Federal Reserve scales back its asset purchases on the stock market in an attempt to restabilize interest rates and slow supply chain shortages.
However, the Fed can’t simply cut off its asset buying, as a sudden stop of the government cash flowing through Wall Street would cause a devastating shock to the market. Instead, it must slowly ramp down its purchasing or “taper.”
At this point, nothing. Until the Fed announces plans to taper, it’s business as usual in the stock market.
However, once the taper announcement comes, there could be massive repercussions. For example, in the 2008 financial crisis, the Fed purchased debt to keep markets afloat and was in a similar predicament of winding down its bond purchases.
The issue was, in 2013, then-Fed Chair Ben Bernanke showed his hand too early and let too many of his bond-tapering plans out during congressional testimony. Investors were already concerned with a potential bond purchase reduction, resulting in a worldwide sell-off of stocks and bonds. This increased stock volatility and shook up the market.
Fortunately, the market stabilized as we moved through 2014, and stocks and bonds began performing well again. This proved the effectiveness of the taper, but it also showed some communication issues need to be ironed out to avoid an initial mass sell-off this time around.
Current Federal Reserve Chair Jerome Powell, a member of the Federal Reserve’s board of governors during the 2013 to 2014 bond taper, saw first-hand what poor communication amid a taper can do.
Suppose Powell can use his past experiences to develop a more tactful way to communicate the bond taper plans and not erode the market’s confidence. In that case, chances are the impact could be minimal. But if investors are left guessing, it could be a repeat of the 2013 sell-off, leading to market instability amid a pandemic that already has investors on edge.
There was some hope we’d hear more about the bond taper plans at the September 21 to 22 Federal Open Market Committee gathering, but that seems unlikely at this point. However, experts believe the Fed will announce plans to iron out the bond taper details at its November 2 to 3 meeting.
What will happen during the taper remains to be seen, as it depends on the communication and the plan Powell outlines with the Fed. If the communication is expertly handled and the taper goes as expected, the markets will likely see slight volatility, but nothing overly dramatic will occur.
However, if the communication comes across as confusing or gets misconstrued, we could see a market dip as investors lose confidence and start selling stocks and bonds.
We should also see a cooling of the related markets, such as real estate and automotive sales. The reason is, as the Fed sells off bonds, interest rates will creep up, pushing some buyers out of the market. However, with demand extremely high and inventory low in these sectors, a cooling of these markets may be for the better.
Either way, experts expect a bond taper to be a slow process, albeit faster than the 2013 to 2014 taper. Some say it could be as long as seven months, so the changes to interest rates should be slow and subtle.