The first month is in the books for the Federal Reserve’s yearslong process of pulling the plug on its bond-purchase program, and markets took things in stride.
It’s a massive undertaking for the Fed, whose investment portfolio swelled to nearly $4.5 trillion. Economists credit the program with helping push U.S. stock funds to returns of more than 300 percent since the spring of 2009.
A worry was that the program’s end would mean pain for the stock market, just like it provided succor on the way up. In the past, even the hint of a slowdown in bond purchases was enough to send investors into a “taper tantrum” and cause interest rates to jump.
But the stock market calmly set more records in October, as the Fed let $10 billion of Treasurys and mortgage-backed securities in its portfolio mature without reinvesting the cash. The pace will gradually rise to $50 billion per month by the end of next year.
The bond market was more exciting in October, as the yield on the 10-year Treasury touched its highest level since March. Much of the increase was the result of a strengthening economy, along with anticipation of President Donald Trump’s choice for the next Fed chair.
A lot is riding on whether markets can remain calm as the program further winds down. Studies have suggested it was powerful enough to pull the yield on the 10-year Treasury note down by 1 percentage point as of the end of last year, when it was around 2.47 percent.
Most analysts expect a gradual increase in the 10-year yield from the current 2.35 percent, as the Fed continues with the portfolio unwinding and raises interest rates. But if rates rise faster than expected, say as a result of a burst of inflation, markets could get upset.
A jump in rates would suddenly rob stocks of some of their attractiveness. Even though stocks look expensive relative to history based on how much profits companies are producing, they don’t look expensive when compared against the small interest payments from bonds. If rates jump, investors would likely become much less willing to continue paying such high prices for stocks relative to earnings.
A sharp rise in interest rates would also leave bond fund investors with losses on what are supposed to be the safe parts of their portfolios.
Here’s a look at several reasons why analysts say the market has been so calm about the Fed’s balance-sheet moves so far:
— This was exactly what the Fed wanted to happen. Following the 2013 “taper tantrum,” the central bank has gone to great lengths to telegraph its moves.
Fed officials have said they want the drawdown of the central bank’s balance sheet to be akin to “watching paint dry,” and the program is supposed to run quietly on autopilot in the background.
With President Trump tapping Jerome “Jay” Powell to be the next chair of the Fed, economists expect this to continue. Powell was already a Fed governor, and economists say he is not as aggressive about raising interest rates as some of the other finalists would have been.
Powell should continue the policies laid out by current chair Janet Yellen, economists say. That means sticking with the already stated plan for reducing the Fed’s balance sheet, as well as gradually raising short-term interest rates.
— The economy is better able to stand on its own without as much Fed support. The economy grew at a 3 percent annual rate last quarter, even though hurricanes shut down a wide swath of businesses. The unemployment rate is also at a 16-year low, and other economies around the world are hitting a higher gear.
It’s a much different picture than when the Fed was buying bonds in the years following the Great Recession. Then the economy needed the stimulus. Plus, the cumulative effect of all that aid for the economy means financial conditions are still relatively easy now, even after the Fed has begun its slow pullback.
“The Fed has so overdone it for so many years, they’ve taken monetary policy so far out of bounds, that they may have to tighten for a while before they get back inbounds,” said Jim Paulsen, chief investment strategist at the Leuthold Group.
— Other central banks are still pumping lots of stimulus into the global economy. The European Central Bank is still buying 60 billion euros of bonds each month, for example. Even though Europe’s central bank laid out a plan last week to reduce those purchases to 30 billion euros in January, they’ll continue until at least September.
The Bank of Japan, meanwhile, is buying not only government bonds to support its economy but also corporate bonds, real-estate investment trusts and exchange-traded funds.
So, what could upset the market? Inflation pressures may be rising. With the economy already in a healthier position, additional stimulus from the U.S. government through tax cuts or other forms could heat up the economy even more and cause prices to jump. If that were to happen, the Fed may find itself forced to raise interest rates more quickly than expected.
“I think the market is underpricing the potential for inflation going higher,” said Jon Mackay, investment strategist at Schroders. “We could have a shot to the system, and if that happens, the equity market would have to take a breather.”