Markets are adjusting to the Fed’s expected policy tightening

People walk past the Federal Reserve building in Washington, DC on March 19, 2021.

Olivier Douliery | AFP | Getty Images

The Federal Reserve is preparing markets to begin their first monetary tightening since the pandemic began, and investors have begun to prepare for change.

Tapering, as it has become known, is likely to begin in the coming months, almost certainly before the end of the year. Minutes of the Federal Reserve Open Market Committee’s July meeting indicate that officials are preparing for a cut this year.

That means the Fed will start reducing the number of bonds it buys. The central bank buys at least $ 120 billion a month to cut longer-term interest rates and stimulate economic growth.

Recent public comments and media reports, including a Monday on CNBC, suggest purchases are likely to decline until they cease altogether sometime in 2022.

These purchases have become a pillar for stocks and bonds, and the markets have started to adjust.

“We have been well in the taper for months and it is very noticeable in the markets,” said Jim Paulsen, Chief Investment Strategist at The Leuthold Group. “For me, the tapering started in March and it affected everything the way you would imagine it.”

Paulsen pointed out a number of indicators that show the market has responded to an expected slowdown in bond purchases.

For one thing, he noted that market-based inflationary measures had withdrawn. He also noted the “sideways” movement in commodity prices and the flattening of the yield curve. In stocks, small-cap, cyclical, international and emerging market stocks all fell.

Perhaps most importantly, monetary measures, which reacted sharply when the Fed ramped up its bond-buying program in the wake of the pandemic in March 2020, has rapidly declined this year. They fell from a monthly increase of 1.4% in January to essentially unchanged in June – although the Fed continued to buy bonds.

Essentially, the lack of monetary base growth, or M2, shows the waning impact of the Fed’s bond purchases, Paulsen said.

He also noted that the markets have digested the moves pretty well and may not even react when the official cut begins.

“Now it’s like selling the rumor and buying the news,” he said. “I wonder if that’s going to happen with the official tapering.”

There have been some notable other customizations on the market.

One eyebrow-raised move was Palantir’s purchase of $ 50 million gold bars, a move viewed by the data analytics software company as a safeguard against uncertainty.

Such moves, including the continued popularity of cryptocurrencies, indicate ongoing concerns about the potential for Black Swans that could come from surprising developments in politics and geopolitics.

How the Fed can avoid trouble

So maintaining a smooth transition to stricter policies could boil down to communication.

The Fed had a poor record of attempting to undo the adjustment earlier, with markets revolting several times since the 2013 “taper tantrum”. This began when then Chairman Ben Bernanke surprised the markets by speaking about tapering during a public talk, and his successors had their own weaknesses in managing policy.

Janet Yellen, Bernanke’s immediate successor and now Treasury Secretary, famously said that shrinking the Fed’s balance sheet was “like drying paint.” Current Fed chairman Jerome Powell angered investors when he said the same accounting program was “on autopilot,” indicating an adamant stance that markets disliked.

“When you change something this big, there is a bit of uncertainty,” said Yung-Yu Ma, chief investment strategist at BMO Wealth Management. “The market could pause to see how that plays out.”

It is crucial to convince the markets that policymakers continue to monitor data and adjust policies accordingly, Ma said.

“The Fed should stay flexible. That’s the most important thing,” he said. “If they communicate that they will be undogmatic and judge the development of the situation, I think the market would find a lot of comfort in it. The market might be surprised by something that looks less flexible.”

Ma expects the Fed to take the conservative course and says it will be flexible.

The speculation comes amid a series of public statements suggesting that support within the central bank will begin relatively soon.

Boston Fed President Eric Rosengren told CNBC on Monday that he envisions an announcement likely to come at the September meeting, with the actual cuts coming by the end of the year at the latest. He noted that the bond purchases, also known as quantitative easing, “are not nearly as effective as they were when we got out of the financial crisis.”

Still, the bond buying exit “represents a change in one of the main pillars of the US equity rally, not to say THE main pillar,” wrote Swissquote senior analyst Ipek Ozkardeskaya. “Of course, the Fed pulling away support will feel like it’s pulling the rug out from under the market. But no stress.”

Ozkardeskaya said the Fed’s tightening “will certainly be different this time around,” as the move is well wired and interest rates are likely to stay near zero through 2023.

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