The Federal Reserve has played a central role in the pandemic-related economic crisis and recovery of the past 18 months. At the onset of the pandemic, even before many cities and states went on lockdown, the Fed had already slashed its policy rate to zero percent and began expanding its balance sheet. As investors anticipate the Fed reducing its bond purchases or considering raising interest rates, some investors may wonder how this and future Fed actions could affect their portfolios.
What is the Fed’s role?
The Fed’s objective is to keep the economy and financial markets running smoothly. On the economic front, they do so by examining a wide variety of data and targeting a dual mandate of inflation and unemployment. However, long-term economic trends matter little if the financial system seizes up in the short run, as it did during the 2008 financial crisis.
As credit markets faltered in 2020, the Fed pulled out all the stops
Buying corporate bonds was one way to directly contain a spike in borrowing costs (i.e., by providing a floor under bond prices).
Chart: The Federal Reserve’s balance sheet has expanded to over $8 trillion.
Sources: Clearnomics, Federal Reserve
In 2021, the Fed is beginning to react to the stabilizing economy
Today, the financial system has not only calmed, but many argue that it is overextended in many areas. This includes high-flying tech stocks, which have been volatile in recent months, “meme stocks” with significant retail investor interest, and more. Thus, it is not surprising for the Fed to begin to reduce its corporate bond holdings and to consider when it might sell its Treasuries and mortgage-backed securities.
These purchases currently stand at $120 billion per month, or a pace of a trillion dollars every eight to nine months. As is always the case, upcoming Fed announcements will be scrutinized for any hints on the timing and magnitude of these events. Expectations vary, but many believe the Fed will begin unwinding its balance sheet at the start of 2022 and raise rates in 2023.
Sudden changes from the Fed don’t look likely
Although there is certainly the risk of another such event, there are a few reasons for long-term investors to stay calm.
- As disruptive as the 2013 taper tantrum (a previous instance when the Fed announced it would begin to buy fewer bonds) was to fixed income holdings, the typical diversified investor finished the year with strong gains (Source: Clearnomics 2021, calculated based on S&P 500 returning 32% in 2013 while fixed income was down only -2%.). This is because the S&P 500 generated a 32% return in 2013, offsetting the challenges faced by bonds. Bonds recovered soon after the following year. Please remember that past performance does not guarantee future results. Different types of investments come with varying degrees of risk, and there can be no assurance that the future performance of any specific investment will be equal to historical performance levels.
- The Fed has likely learned from that episode and will continue to bend over backwards to avoid a repeat. This means that they may either keep monetary policy looser for longer or be extremely gradual in their approach.
- There is an old debate on whether “tapering is tightening.” In other words, is reducing the pace of bond purchases equivalent to selling bonds from its balance sheet? That is, is it the level or the direction that matters? While this is a theoretical debate, it’s clear that the Fed will likely continue to be a significant buyer of bonds for quite some time.
Regardless of how the Fed approaches tapering and tightening, long-term investors are better off staying focused on their financial goals rather than reacting to every Fed announcement.
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This material, as well as the insights and data within, have been provided to MoneyLion by Clearnomics, Inc.
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