Fed Tapering: What Is It, and Should Investors Prepare for a Taper Tantrum Part 2?

As you’ve probably heard or seen in headlines, the Federal Reserve is likely to start reducing Treasury bonds and mortgage-backed securities purchases in November — or begin “tapering” — ahead of previous projections for 2022.

First things first, why is this such a big deal?

Well, the last time the Fed tapered in 2013, during the recovery from the 2008 financial crisis, markets panicked and pitched a “taper tantrum.”  That’s because traders worried that less Fed support would hurt fundamentals and potentially cause a market downturn.

That old taper tantrum narrative is making people worry that another market downturn could be ahead of us, especially with concerns about the Delta variant of COVID-19.

Before we dive into what could happen, let’s talk about where we are and how we got here.

When the COVID-19 pandemic started, the Federal Reserve slashed interest rates and began buying $120 billion a month in bonds and mortgage-backed securities to reduce interest rates, lower borrowing costs and give businesses and the economy a boost.

But now that the economy is much stronger, the employment situation has improved and inflation is a concern, the Fed wants to start paring back those asset purchases to return interest rates to a more “natural” level.

We don’t know exactly when or how the Fed will decide to act, but analysts have some pretty good guesses. The latest prediction by Goldman Sachs suggests tapering could start this November, as the Fed gradually pares back asset purchases through next year.

The takeaway is that the Federal Reserve isn’t going to stop buying assets and raise interest rates immediately — it’s going to gradually remove the support and see how the economy reacts.

The main reason people worry about Fed reducing support is because of the effect that higher interest rates could have on stocks, particularly companies that rely on borrowed money. However, interest rates are just one piece of the puzzle. Economic fundamentals, earnings and other factors also weigh on stock prices.

With the benefit of hindsight, we can see that the 2013 taper tantrum wasn’t even that bad. The S&P 500 tumbled 5.8% over the course of a month but quickly recovered.

The caveat is always this: The past does not predict the future.

I think the main reason markets declined last time was that investors hadn’t experienced tapering before; they didn’t have context for what the Federal Reserve would do. Since we’ve seen this happen before — and fairly recently — I think that the uncertainty is lessened. However, we also have other worries to consider: A deteriorating crisis in Afghanistan, continued pandemic worries and political wrangling over infrastructure.

Any of these factors could derail the bull market.

But it’s not going to be the end of the world — corrections are always something we should expect. They happen regularly and are a natural part of markets.