The Federal Reserve Has Not Yet Begun to Taper

Although the market seems to have staged something of a recovery since the January sell-off, there is a very good chance that the worst isn’t over for stocks. The big fear gripping Wall Street in January was that the Federal Reserve planned to taper its bond purchases and raise interest rates.

The reversal of the stimulus it had pumped into the market since the pandemic started would likely mean money that had flowed into the stock market would likely flow back out, to be spent or invested elsewhere.

With the market wafting back upward, it might seem like the worst of that fear has passed. There’s only one major risk with that sentiment: The Fed has not yet begun to taper. Indeed, it is still expanding its balance sheet, which now sits in the vicinity of $9 trillion. The chart below shows the recent details and trends.

Image source: Board of Governors of the Federal Reserve System.

Why the other shoe might still drop

While the Federal Reserve is talking a tough game with respect to tapering and interest rates, what it is actually doing is continuing to pump cash into the bond market while holding rates near zero. Indeed, it plans to keep buying new bonds at least through February, only really starting to taper those purchases in March.

As a result, the market’s fear of the Fed tightening is currently up against the reality that the Fed is still putting drunken sailors to shame with the rate at which it’s throwing money around.

As the market recovers some of its January losses, investors have every right be worried about how much of that recovery is due to the continued infusion of Federal Reserve cash. After all, if rates haven’t really risen yet because the Fed is still an aggressive bond buyer, then other investors haven’t yet had the chance to really downshift their investments into lower-risk assets.

If the Federal Reserve really does taper its buying, other buyers will have to step in. After all, the U.S. government still expects a nearly $1.7 trillion deficit for this year, and all the new debt it creates has to be absorbed by some new buyer. If the Federal Reserve tapers and stops injecting new cash to do that, rates will naturally increase as investors who can’t (legally) print their own cash step in to fill the void.

As those rates rise, lower-risk assets like bonds will start to look relative more attractive to investors, thus enabling a return to the down market we saw in January when the Fed merely threatened to taper. Actions, as they say, speak louder than words, and if and when the Fed actually does taper, there’s a really good chance there could be another leg down in the market.

Image source: Getty Images

What can you do about it?

First and foremost, make sure your own debt situation is in control. If you have debt, now is a great time to lock in low, fixed-interest rates while you still can. It’s still possible to get 30-year mortgages for around 3.25%, which is well below the current inflation rate. If the Fed tapers and rates rise, the cost for new debt will go up, and most existing adjustable-rate debts will see their rates increase as well.

Next, if your portfolio strategy calls for you to own bonds, check your current modified durations, and consider lowering your duration-related rate exposure. As a general rule with all else equal, longer-term and lower-coupon bonds tend to perform worse in a period of rising rates. Keeping your durations short can minimize your exposure to price declines in your bonds as rates rise, helping you protect the value of your existing bond investments.

Beyond that, be sure that you really do have a long-term time horizon for the stocks that you own. If you expect you’ll need the money in the near term, the volatility in the market might make it difficult for you to find more-attractive exit points. It’s always dangerous to rely on stocks for money you might need soon, and that’s particularly true if there are good reasons to believe the market could crash again.

Time is ticking

The Federal Reserve’s current plans call for tapering to begin by March. Since the Fed’s balance sheet clearly shows that the tapering hasn’t really yet begun, this month may be your last, best chance to get yourself prepared for what could be a return to a rocky stock market. With inflation still trending around 7%, we may find ourselves in a rising-rate environment for quite a while to get those price hikes in check.

Getting prepared now could wind up being the best gift you can give yourself as we navigate a rising-rate environment the likes of which American investors have not seen for decades. With the Federal Reserve telegraphing that its move to actually taper will be starting soon, time is running short to get yourself ready. So get started now, and improve your chances of navigating what could be some rough markets ahead.

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Chuck Saletta has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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