The Fed could start to “wane”. Don’t expect this to wreak havoc on the stock market.

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Federal Reserve Chairman Jerome Powell.

Win McNamee / Getty Images

The Federal Reserve is set to cut the size of its bond buying program, so stocks may come down soon. The pain may not be acute, however, as investors generally expect the Fed to do just that.

It was a different scenario in May 2013, when Ben Bernanke, the Fed chief at the time, told Congress that if economic conditions continued to improve and policymakers were confident it would continue, the bank could reduce its purchases. Bond yields surged and the

S&P 500

fell 5% in five days in an episode known as Taper Tantrum.

As bond yields rose, stocks became relatively less attractive, especially as the bank signaled it would provide less support to markets and the economy. The Fed finally announced a reduction in its purchases in December of the same year.

This time, investors are already expecting a Fed cut. The central bank has telegraphed the change in monetary policy several times. Government bond brokers expect the Fed’s monthly bond purchases, as part of its efforts to support the economy as the pandemic hit, to drop from the current $ 120 billion to zero. ‘by the start of 2023, according to a

Goldman Sachs

investigation.

Stocks are already valued in a way that makes higher bond yields seem plausible. The S&P 500 equity risk premium – the percentage return on earnings and dividends for the average index stock, minus the yield on 10-year Treasury debt, is currently around 6 percentage points , according to Goldman Sachs. The number represents the additional return over the safe bonds that investors demand to be in stocks.

This is higher than the below 6% levels often seen since 2010, implying that even if bond yields rise, reducing the risk premium of equities, equities would still offer relatively strong returns in historical terms. “Market participants seem to be aware of the reduction,” writes David Kostin, chief US equity strategist at Goldman Sachs. “The equity risk premium remains high compared to history.”

Others agree that the markets are anticipating a cut by the Fed. “An orderly and transparent removal of accommodative monetary policy should not be disruptive, particularly if undertaken in response to improvements in the underlying economy,” wrote Jason Pride, investment director for private wealth at Glenmede.

At the very least, investors should be watching how much money the Fed is withdrawing from the bond market and how fast it is doing so. A massive sell off in response to the mere news that the Fed is shrinking is far from certain.

Write to Jacob Sonenshine at [email protected]

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