Federal Reserve to taper bond purchases

October 13 | Market news

Investment markets tend to pay close attention to actions of the Federal Reserve (the Fed), its monetary policy stance and the potential for changes to that policy. The focus on the Fed has stepped up recently in light of speculation of a potential shift in policy in the coming months.

Federal Reserve chairman Jerome Powell has indicated the Fed will begin to scale back measures it took early last year to help prop up the economy. This comes during a period of sustained, solid economic growth after the severe, pandemic-fueled recession in 2020. What specific actions can we expect from the Fed and how should investors assess the impact of these changes on their own portfolios?

Background on the Fed’s role

The Federal Reserve acts as the U.S. central bank. While its functions include maintaining an effective payment system and overseeing bank operations, markets are most interested in the Fed’s monetary policies.

In setting monetary policy, the Fed attempts to fulfill three mandates:

  • Price stability. The Fed seeks to maintain a stable inflation rate. Its current target is inflation averaging 2 percent per year.
  • Maximum sustainable employment. Often referred to as “full employment,” it technically refers to a labor market where the unemployment rate is at a low level. The Fed’s current target is to attain an unemployment rate of 4.1 percent.
  • Maintain moderate long-term interest rates. Because the level of interest rates can impact economic activity from consumer mortgages to business financing, the Fed seeks to keep rates at modest levels.

The Fed also influences short-term interest rates, specifically, the so-called federal funds (or fed funds) rate, which is the interest rate applied on overnight loans from one financial institution to another. While Fed chair Powell receives most of the attention, the Federal Open Market Committee (FOMC) establishes Fed monetary policy. It is the committee that sets the fed funds rate target and has other authority, including buying and selling of securities.

The era of “quantitative easing”

Along with adjusting short-term interest rates, another strategy the Fed has used in more challenging economic periods is known as quantitative easing (QE). In these instances, the Fed uses its purchasing power to buy longer-term securities on the open market. By investing in securities (typically in the fixed income market), the Fed adds liquidity to encourage economic activity through more lending and investment. This strategy is particularly useful when adjustments to the fed funds rate are no longer possible if the rate is already at an extremely low level.

The Fed utilized QE from 2009-2014 in the wake of the financial crisis. It purchased bonds, mortgage-backed securities and other assets, seeking to create more liquidity in the market. The goal was to encourage banks to keep lending and investing the reserves created by the Fed’s purchases to stimulate economic growth at a time when the economy seemed to be on shaky ground.

Similarly, as the COVID-19 pandemic emerged in March 2020, the Fed implemented a QE strategy and immediately injected more than $700 billion in asset purchases. In June 2020, it implemented QE again to purchase $120 billion of bonds per month – $80 billion in U.S. Treasury securities and $40 billion in mortgage-backed securities. That program has remained in place since.

“Under this program, the Fed has been one of the biggest buyers of Treasury securities in the market,” says Tom Hainlin, national investment strategist at U.S. Bank. “They had an impact on the interest rate environment just by their large presence.” Hainlin notes that with the Fed bumping up demand for bonds, long-term interest rates remained low (high demand for bonds typically helps keep interest rates lower).

This coincided with the Fed’s move to reduce the fed funds rate dramatically in the early weeks of the pandemic. It lowered the fed funds target rate from 1.75% in February 2020 to 0.25% about one month later. It has remained at that level, what observers refer to as a “zero interest-rate policy” or ZIRP, since that time.

Fed interest rate adjustments

While the Fed’s choices related to buying bonds tend to affect interest rates on the long end of the yield curve, setting the target fed funds rate directly impacts the short end. Chairman Powell has repeated frequently that the Fed would not likely adjust short-term rates from the current “near zero” level until 2023.

Yet there were hints from the FOMC in September that a change could potentially occur sooner. A significant number of FOMC members and others who forecast the fed funds rate indicated an expectation of higher rates yet in the coming year. That is the first sign of the potential for an accelerated pace to interest rate hikes.

Shifting sands raises questions

The economy has bounced back after the severe recession in the first half of 2020. Growth in the first half of 2021, as measured by Gross Domestic Product, exceeded an annualized rate of 6%, significantly higher than long-term averages.1 At the same time, inflation accelerated, with the Consumer Price Index growing at more than a 5% annual clip in recent months, again much higher than recent averages.2

In an environment of faster economic growth and higher inflation, many analysts have speculated that the Fed would begin to take steps to pull back its monetary easing efforts. Chairman Powell formally reported the first signs of that in September, when he indicated that the Fed would start to “taper” its QE strategy. The process could begin as early as December, and Powell signaled bond purchases may come to an end by mid-year 2022. “That may be a more aggressive pace of tapering of bond purchases than many anticipated,” says Hainlin. Yet Powell stated that Fed policy “will remain accommodative until we have reached the central bank’s goals on (maximum sustainable) employment and (stable) inflation.”3

This prospect raises various questions for investors.

  • Fixed income market. Much of the focus will be on the potential impact on interest rates. As the Fed scales back its purchases, it will lessen the demand for bonds. “If you have the Fed stepping away from the business of buying Treasury bonds,” says Hainlin, “it may occur at a time when supply is increasing due to new federal spending.” The expectation, he suggests, is that interest rates will trend upward on longer-term government bonds.
  • Residential real estate. If the Fed also tapers its purchases of mortgage-backed bonds and eventually brings that process to an end, mortgage rates could go higher. Hainlin sees more room for maneuvering here. “While home prices have risen significantly, people are still buying houses, so that indicates the market is healthy.” Given that situation, Hainlin believes that a modest rise in mortgage rates as a result of the Fed’s change may not be a major deterrent to healthy activity in the housing market.
  • Inflation. Persistent high inflation rates may result in higher interest rates, which could affect calculations of projected future cash flows that analysts use to determine the present value of a stock. Higher rates generally dampen expectations for stock valuations going forward, though investors also weigh expectations for economic and corporate profit growth.

Expect the environment to begin to change

Investors should be prepared for the possibility that long-term interest rates will begin to head higher. We’ve seen that before. In late 2018, the yield on 10-year Treasury bonds topped the 3% level. But they eventually dropped below 1%, and as of the end of September 2021, stood near 1.5%, their highest level since the early weeks of 2020.

Hainlin points out that higher rates can be beneficial for fixed income investors who rely on the income bonds can generate. Higher interest rates can also provide a boost for stocks in specific industries, such as financials, industrials and select consumer goods. Companies that have achieved relatively high valuations in today’s market, such as technology stocks, may not look as attractive on a relative basis if rates trend higher. However, they retain longer-term appeal due to positive trends in digitization, artificial intelligence, machine learning, mobility and e-commerce that extend well beyond COVID-19.

Be sure to consult with your financial professional to review how your portfolio is currently positioned and if changes might be appropriate given expectations for what could be a changing investment landscape.

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