When the Federal Reserve (Fed) starts tapering, as it has already started doing, chances are your portfolio has already been affected by the Federal Reserve’s decision even if you don’t invest in the US. We’ll talk about what you can expect during tapering and what is to come for your portfolio.
What is tapering?
Tapering, in simple terms, is the reduction of money printing by governments. Printing more money is called quantitative easing (QE) and is a popular measure for governments. When the Federal Reserve is tapering, they are taking more assets on the balance sheet. Tapering usually happens after a crisis when the economy is picking up again.
What is the point of quantitative easing?
QE supports the citizens and entities during an economy in recession. This monetary policy has significant advantages like low-risk lending. Low-risk lending is possible because interest rates have usually already dropped to 0 percent times of economic downturn. Due to low-interest rates, the Federal Reserve can quickly add money to the economy. This ‘easy money’ makes it easy for consumers to spend money and take out new loans, helping the economy grow and getting the proverbial train going during an economic downturn.
In addition, quantitative easing increases asset prices. For example, when the government participates in bond purchases as part of a QE policy, the bonds are replaced with money that the prior bondholder can reinvest in other assets in different financial markets, enhancing their value.
Why tapering is vital for your portfolio
While of importance to your portfolio, tapering also significantly impacts the way you spend your money. It’s important to note that tapering refers to central banks and directly influences the interest rate on mortgages, personal loans and loans for businesses.
When the fed starts tapering, the most immediate result is bond investors selling their assets, which causes prices to go up on 10-year US treasuries. Bond investors sell their assets during tapering because economies often experience tapering when the economy is strong.
Tapering does significantly hurt global markets as it leads to tighter conditions financially and causes a tremendous amount of volatility in the stock markets. In addition, less leverage is used in the markets, decreasing asset prices further. However, others argue that the stock market seems to perform well during the 12 months after tapering. Good performance following tapering is because the Federal Reserve usually only tapers during strong economic times.
How to hedge against tapers
Investors should be wary of their passive growth funds or securities during tapering activities from the Fed, as they are often hit hardest by tapering. More brutal hits happen because higher interest rates effectively decrease the total value of future results from companies. It can be advisable to redeploy your cash into reasonably valued companies that are tied to economic growth and pay out steady dividends.