It appears that the Fed will end its bond purchasing program by the end of the first quarter 2022. Once completed, it is likely the Fed will start raising Fed Fund Rates to fight inflation. So what does this mean for your portfolio?

The Fed’s recent announcement of tapering purchases of Treasuries and Mortgage-Backed Securities (MBS) has some investors concerned about their portfolios. History tends to repeat itself, and while few financial market circumstances are ever identical, they can follow similar trends. While investors are wise to be cautious, there are several wealth management strategies they can employ to navigate the Fed’s tapering plan.

At the beginning of the Covid-19 pandemic, governments throughout the world shut down non-essential businesses in an attempt to control the spread of this deadly virus. The U.S. economy came to a screeching halt, experiencing its greatest quarterly drop since the Great Depression. The Fed enacted a bond purchasing program to inject money back into the economy in an attempt to help prop it up. In a move similar to the 2008 global financial crisis (GFC), the Fed dropped rates to zero percent and then began buying bonds in the open market to reduce bond yields to encourage people to borrow money or improve their cost of carry by refinancing existing debt at lower rates. They looked to increase liquidity in the market, encouraging economic growth and stability. The plan was to eventually cut back the purchasing of bonds and let the market reorient itself to pre-GFC levels.

The Fed began tapering $15 billion in November, with the thought to end all bond buying by the summer. Lofty inflation figures pushed the Fed to expedite their tapering, doubling their cutback by $30 billion in December and commenting that they will adjust the amount each month as needed. It is now thought that the Fed will end their bond purchasing program by the end of Q1 2022. How might the Fed’s tapering plan affect your portfolio, and what management strategies can you employ to shield your wealth from volatile market fluctuations?

Understanding Wealth Management Strategies 101: How Do Bonds Work?

Before diving into how the Fed attempts to influence the economy through bond purchasing, it helps to first understand how bonds work in general. Governments, corporations, and municipalities can raise money by issuing debt in the form of bonds. Why not just borrow from the bank? Well, the borrower may not be able to meet the loan requirements, and at times the borrower is raising debt at levels beyond the capabilities of a single bank. The interest rates on bonds also tend to be lower than what one would pay to the bank, making fundraising through bonds a more attractive avenue.

For example, say a major corporation is looking to build a new factory, which will cost $1 million. Instead of seeking a bank loan, the corporation decides to raise money through private investors. They issue 1,000 bonds at $1,000 each, promising annual interest rates of 5%. Interest rates are set per free market evaluations. If the company sets its interest rate too high, it could lose money and possibly even default on the bond. Conversely, the borrower risks not raising the capital if their bonds bear too low interest to make them attractive.

The borrower also determines when they will pay back the principal to the lender—the $1,000—back to the investor or what is also known as a maturity date. In this example, let’s set the bond’s maturity date to five years from time of purchase. Therefore, if you buy the bond, you’d make $50/year for five years, at which point you’d get your principal back, leaving you with a total of $1,250.

When the Fed is looking to control interest rates on the open market, they engage in open market operations (OMO) where they buy or sell treasury bonds. They’ll buy bonds to infuse money into the economy. The increased demand increases the price of bonds, thus lowering current yields. Conversely, if the Fed starts selling bonds, the price of bonds on the open market goes down, while interest rates go up.

OMO operates on the basic principle of supply and demand. If the government buys up a significant portion of bonds, private investors will pay more for what’s left, thus driving the price up. However, when the government sells off bonds from their balance sheet (currently sitting at $8.6 trillion), supply goes up, thus lowering the bond price while raising interest rates.

Our governments bond purchase program has created artificially low interest rates. While this stimulus can have positive affects on the economy in the short-term—more money for people to spend and borrowing at lower rates —this only works up to a certain point before it negatively impacts inflation. Why? The number of goods and services is finite. Just because there’s instantly more money in the economy doesn’t mean there are more products. When people have more money to spend, the cost of goods and services goes up, thus increasing inflation.

High inflation rates are rarely good, especially if the increased cash flow is only short-term. That’s why the Fed is careful about over stimulating our economy. Too much stimulus could send the economy into a spiral of high inflation, and even the most expert wealth management strategies may not be enough. For this reason, it makes sense that the Fed plans to taper spending as the economy repairs itself and businesses reopen.

What Is Tapering?

illustration of wealth management strategies using blocks

When the economy shut down in March 2020, the Fed had to do something to prevent a complete economic crash. They reduced short-term interest rates to zero, and began a large-scale asset purchasing process called quantitative easing (QE). From June 2020 to October 2021, the Fed spent $120 billion/month buying treasury securities and mortgage-based securities (MBS). As the economy continues to heal itself, the Fed has announced the tapering of purchases.

Tapering simply means to “cut back” spending. The Fed still plans to buy bonds each month, just less and less as time goes on. In November, the Fed announced they would spend $15 billion less each month until they stop buying altogether. The idea is to slowly remove monetary stimulus as the economy gets back to pre-pandemic levels. The Fed took a more aggressive stance in December, announcing they were going to cut their bond purchasing by $30 billion each month due to elevated inflation readings. The Fed has made clear that tapering could lead to an increase in short-term interest rates. While it’ll reduce the amount of QE, those who lived through the 2008 GFC will recall how a more austere monetary policy led to the Taper Tantrum of 2013.

The Taper Tantrum

The last time the Fed engaged in QE was during the GFC. Once they were convinced the economy was bouncing back, (former) Federal Reserve Chair Ben Bernanke announced the plan to scale back purchases—tapering. The bond market went wild overnight, as investors knew that if the government tapered spending, the value of bonds would go down. The bond market crashed as investors sold off US treasury bonds. The Fed’s QE program represented such a high demand percentage that the thought of them leaving had a profoundly negative effect, although those fears were purely speculative.

Could we experience a repeat of the Taper Tantrum today? Most likely not. This time around, the Fed has been much clearer about their tapering plans. However, the Fed recently hinted that inflation levels are perhaps stickier than initially believed, evident by Chairman Powell’s desire to retire the word “transitory” when describing the current inflation. If inflation levels continue along this trajectory, the Fed may have to expedite its tapering plan to keep up.

How Can Investors Make Smart Moves?

The Fed’s tapering plan is a sign of confidence. The decision to scale back purchases means they believe the economy is making a comeback from the Covid-19 pandemic. It appears that the Fed will end its bond purchasing program by the end of the first quarter 2022. Once completed, it is likely the Fed will start raising Fed Fund Rates to fight inflation. So what does this mean for your portfolio?

Unfortunately, the Fed’s planned course of action may negatively affect your portfolio if you’re not employing sound wealth management strategies. The tapering plan directly impacts the bond market and bonds in your portfolio. Once the Fed stops purchasing Treasuries and MBS, demand will go down along with the price. Remember, lower prices mean higher yields.

The Fed’s most recent outlook on inflation suggests they’ll raise rates once the bond purchasing program is complete. It would be counterproductive to raise rates while they are still buying bonds, as their purchasing activities stimulate the economy, while raising rates slows it down (and scales back inflation). Investors in the bond market can expect prices to sink in the next year and a half while interest rates increase. So, how big of an impact can it have?

The Fed announced they plan on raising rates three to four times next year. At 25 basis points each, that would mean a minimum of 0.75%. Even a 1% rise in interest rates can impact your portfolio. Say you hold a portfolio split between 50% stocks and 50% bonds. As the economy bounces back, you can expect upwards of 9% historical returns on your stock portfolio (if your positions are in S&P 500 stocks). However, your 50% bond position could see a 7.3% loss with a 1% rate increase as those bonds lose purchasing power. Even with a historical return on your stocks, with 5% inflation and rising interest rates, you’re looking at a -3.3% real return.

The stock market isn’t impervious to rising interest rates either. Companies holding large amounts of debt, especially short-term debt, could see an impact to their quarterly earnings due to margin compression. This could come in the form of higher borrowing costs or higher cost of goods. Either could impact earnings expectations. Changes in interest rate policy can create a minefield of problems that investors need to be aware of.

POLARIS PRO TIP: Polaris CIO Jeff Powell urges investors to lower your exposure to bonds and if you are unwilling to sell your bonds shorten the duration of your bonds to limit the negative impact of rising interest rates. The bonds most susceptible to loss in the wake of higher rates are those going out 10, 20, and 30 years. The impact of a 1% increase in rates could spell disaster for long-term bond programs.

Keep Ahead of The Fed in 2022—Talk to a Wealth Manager Today

Keeping tabs on the Federal Reserve is a key part of effective investing and smart wealth management strategies. Understanding the Fed’s tapering agenda and how it may affect your portfolio could mean the difference between losses and gains next year.

The experts at Polaris Wealth Advisory Group are here to answer any questions you may have about upcoming financial planning and investments. Contact a Polaris Wealth expert today to better understand and plan your future in 2022 and beyond.

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