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The Fed Could Start Pulling Back on Support Next Year. What That Means for Stocks.

As the economy heats up, the Federal Reserve may start reducing the size of its bond-buying program, removing one layer of stock-market support.

In the Fed’s December minutes, released this week, Federal Open Market Committee members highlighted the economy’s recent strength, saying that it has shown “resilience in the face of the pandemic.”

The economic recovery has been mostly V-shaped. Fiscal stimulus is expected to keep consumers and small businesses more than afloat and ready to spend cash and rehire workers when the millions of expected doses of Covid-19 vaccines are distributed—though distribution has been slow. If the economy truly recovers as fast as expected, the FOMC may indeed take its foot off the gas pedal.

Some on Wall Street expect it.

Weeks after Citigroup strategists and Morgan Stanley economists floated the possibility that the Fed will reduce the size of its program, Morgan Stanley economists wrote in a note Thursday that the possibility is becoming closer to reality. Economist Ellen Zentner wrote that the Fed’s minutes mean “we see the FOMC tapering its asset purchases beginning in January 2022.”

The central bank has been purchasing $80 billion of Treasuries and $40 billion of mortgage bonds a month to keep bond prices high and interest rates low, stimulating economic activity. The Fed has made clear it would continue this as long as the economy needs.

But this is a sensitive issue for investors, not only because the Fed hasn’t given quantified guidance on when it will alter its program, but also because of memories of the “taper tantrum” of 2013. That was when the Fed reduced the size of its crisis-related purchasing program, sending bond yields higher and putting the economy at risk. When the Fed raised rates at the end of 2018, the S&P 500 fell 16% in less than two months.

The Fed would likely reduce the size of its program before raising short-term interest rates above the current 0%-0.25% range, which it is unlikely to do until at least 2023. Zentner, citing the Fed’s mention of its gradual tapering in 2013 and 2014, said it is likely to reduce the size of purchases by about $10 billion in Treasuries and $5 billion in mortgage bonds in 2022.

If the Fed buys fewer bonds, their prices would be pressured. Rates, which move inversely to prices, are likely to rise. Higher interest rates pressure stock valuations because they make the risk of being in stocks less attractive against buying safe Treasuries.

Valuations are currently incredibly high historically because of low interest rates, but if the higher rate dynamic plays out, it is likely to indicate a firming economy, which indicates growing earnings, which could outweigh falling valuations.

Just don’t buy stocks if the Fed starts easing too quickly.

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