Telemus Weekly Market Review August 30th - September 3rd, 2021

What’s with the Taper?

The market has a habit of picking apart economic data in an attempt to extrapolate the future. These days all eyes are on the Federal Reserve and when they will begin to taper. The taper refers to the next step in the Fed’s monetary policy where it will slow the pace of its monthly bond purchases. Currently the Fed is buying $80 billion a month worth of Treasuries along with $40 billion of mortgage-backed securities.

This past week, we saw the August employment report disappoint. Not because the unemployment rate went up, in fact it fell by two tenths of a percent to 5.2%. However, the number of new jobs added was a disappointment. In total the reported 235,000 was well below the 750,000 that economists had expected. Hence the debate continues as to whether the Fed will taper in September, November, December or into 2022. The expectation, which has been set by Fed Chair Jerome Powell, is that the Fed will begin to taper by the end of the year.

So why all the fuss around the taper? Well for starters, the Fed’s purchases of $120 billion a month accounts for a heavy supply of buying power in the Treasury and mortgage markets. The general expectation is that as the Fed starts to slow its purchases, that will lessen demand on these bonds and could lead to slightly higher rates. It will also remove some artificial demand created by an indiscriminate buyer. While the Fed’s current purchases are purely focused on Treasuries and mortgages, the taper may have second order impacts on other parts of the bond market. Corporate bonds are trading at record low yields in part because of low yields on Treasury bonds, but also because the Fed’s purchases have pushed bond investors to other parts of the fixed income market. Maybe the yields on these instruments might themselves be too low once the Fed begins to let its foot off the gas.

Outside of bonds, stocks have also been an indirect beneficiary of the Fed’s bond buying. Low yields have resulted in equities benefiting as investors have chosen to take on more risk and increase their stock allocations in order to and hit their return objectives. Low interest rates have the tangential impact of benefiting those stocks where more of their value is derived well off into the future. This has especially been a boon to stocks that have high revenue and earnings growth expectations.

The open question is whether the Fed tapering its bond purchases will cause a shift in the market. It wouldn’t be surprising to see interest rates rise, particularly intermediate and long-term interest rates. We may see more divergent returns across different sectors of the bond market. In addition, even modestly higher long-term rates could lead equity investors to shift preferences toward different sectors and styles of stocks than have more recently been in favor. After what has been a fairly calm market in 2021, the taper could be the elixir to stir up the relative predictability of stock and bonds as we head into the next phase of the monetary cycle.