With the economy reopening and more Americans receiving COVID-19 vaccinations, the economy is expected to be operating on all cylinders. However, some economists and market analysts are afraid The Federal Reserve may create a “taper tantrum” if and when it starts to reduce its purchase of U.S. Treasury debt. The Fed’s current track of purchasing $120 billion of U.S. Treasury debt every month has kept the 10-year yield moderated. However, if The Fed signals fewer monthly purchases from current levels, recent history has already seen higher 10-year yields and increased market volatility.

As the Federal Reserve Bank of St. Louis outlines, the Federal Open Market Committee (FOMC) holds meetings eight times a year to evaluate the country’s economic conditions and determine the forward monetary policy. This includes what they will do (or not do) to the federal funds rate, which is the rate that financial institutions charge each other for overnight interbank lending.

Whatever the FOMC decides to do with the federal funds rate, it’s important to know that any changes to the federal funds rate impacts short-term interest rates, such as the three-month Treasury bill. Depending on how it’s modified (increased or decreased), the rate change impacts consumer and business loans and longer-term debt.

When the FOMC raises or lowers the federal funds rate, it sends a policy directive specifying the new target range to the trading desk of the New York Fed. Depending on the target rate of the new fed funds rate, more government securities will be bought to lower the rate, or government securities will be sold to raise the new target. This is accomplished through its open market operations (OMO).

OMO is made up of two parts. The Fed buying or selling U.S. Treasury bonds, for example, consists of the operations part of OMO. Since the Fed relies on the trading desk of the New York Fed to accomplish its goals, it uses the open market to purchase these securities through the traditional bid and offer trading method. It’s one tool in its toolbox to accomplish the dual mandate policy of maximizing employment and maintaining price stability.

Depending on which way the Fed goes – either tightening or loosening its policy – it tries to steer the level of the banking system’s reserves, creating a shift in interest rates. For example, when the Fed buys Treasury bonds, it adds capital to the purchasing bank’s reserve balance to increase lending through lower interest rates. When the Fed sells its U.S. Treasury bonds, it moves the federal funds rate upward. This lowers banks’ reserves, causing financial institutions to increase lending costs.

When it comes to the term “quantitative easing,” the Federal Reserve Bank of St. Louis defines it as “large-scale operations of the purchase of large amounts of longer-term U.S. Treasury securities and mortgage-backed securities.” One noteworthy consideration for OMO is that when the federal funds rate is near zero, which occurred during the 2008-2009 financial crisis, quantitative easing is one more tool in the Fed’s toolbox to help the economy dig itself out of a downturn and provide liquidity.

Tapering in Action

According to the Federal Reserve Bank of St. Louis, when tapering was even mentioned, it had negative effects on the markets. After continued quantitative easing was instituted to rescue the economy from the 2008-2009 financial crisis through part of 2013, the Fed made comments regarding these efforts in its FOMC meeting and during its press conference on June 19, 2013. It indicated that it would begin “tapering” (gradually lessening) its monthly bond purchases during the end of 2013, assuming economic conditions were improving. However, the market reacted badly to these comments.

U.S. 10-year bond yields spiked to 2.35 percent within hours of the FOMC meeting and press conference on June 19, 2013. On June 21, 2013, the 10-year bond yields climbed farther to 2.55 percent. Similarly, the same meeting prompted a spike in “normalized foreign exchange per USD rates,” according to the St. Louis Fed. In the two days from June 19-21, 2013, the U.S. dollar gained between 2 percent and 3 percent in value against the Euro, the British pound, the Canadian dollar, and the Japanese yen.

Conclusion

Looking at markets on June 19, 2013, when the Fed announced the tapering, the Dow Jones fell more than 200 points, the S&P dropped 1.4 percent and the Nasdaq finished 1.1 percent lower.

Retail and institutional investors can’t predict the future, but they can look at the past and monitor upcoming Federal Reserve events to see what it might end up doing to the stock market.


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