The financial world is full of a lot of jargon that most people don’t care to learn. Just look at the bond market and you’ll hear words like coupon, spread, ask, yield, yield to maturity, discount, par, and more. It’s enough to make you never want to look at the market again. Fortunately, there are financial advisors out there that learn the jargon and interpret all of that for you. But, there are some things, such as quantitative easing and tapering, that can drastically affect your portfolio.
What Is Quantitative Easing?
The way it works is that when the economy is slowing down, the Federal Reserve gets together to come up with solutions to prevent a huge market crash (or slow one that’s already happening). One way to do that is to boost the economy back up by giving everyone extra money. This extra money is spent, loaned, saved, and used to increase cash flow. Businesses are given a kick start because people are spending money; they, in turn, need to buy more supplies so manufacturers are given a boost because they have more business. All in all, the economy gets a nudge back in the right direction.
But QE is much deeper than giving citizens money. It takes on many forms, such as QE2 where the Fed bought $600 billion in U.S. Treasuries. Or perhaps consider QE3 where the Fed is buying mortgage-backed securities in an effort to help prop up the housing market. These are all huge programs that go largely unnoticed by the general populace, but their effects don’t go unnoticed.
What Is Tapering?
When the Fed is pumping money into the economy, life seems pretty good. Everyone has money, businesses are booming, and things are flowing smoothly. But these are never meant to be long-term solutions, and they can become very dangerous to the value of the dollar if they are left going too long. They can also be very dangerous if they are cut off too quickly. To alleviate the worries, the Fed will curtail its bond-buying program, which is called "tapering."
Instead of suddenly stopping their easing programs, the Fed will slowly wind them down. Let’s suppose that they are buying $10 billion of securities this year, and that next year, they are buying $8 billion worth, and so on until they are not putting money into the economy and it can support itself. It sounds good on paper, but sometimes it doesn’t work out so well.
Throwing a Taper Tantrum
You have probably heard that the stock and bond markets are rather fickle. They are reactive and overall not a very good indicator of economic health. What happens after the Fed starts to taper off easing is just that: a reactive response to something that might be bad.
Back in 2013, the Fed turned off one of their QE programs (or rather tapered it off). When that news was announced people panicked and money started pouring out of the bond market. The result was that bond yields increased dramatically. Since that time things have largely leveled out and investors have realized there was no need for a massive panic.
Now, we are poised for a second Taper Tantrum. There is a lot of speculation that the Fed will raise interest rates. The prime rate, set by the Federal Reserve, dictates how much banks can borrow or lend to and from each other, and the consumer interest rate is directly tied to the prime rate. The higher the prime rate, the more individuals must spend on loans.
If the Fed does raise rates (some experts say it is time, while others say they won’t be able to due to economic instability), they expect that the market will throw a Taper Tantrum. They would like to avoid a repeat of the tantrum that happened back in 2013, but that may not be possible.
In reality, when the rates go up, perhaps not this year but likely in the next couple of years, the market is bound to react. Money will flow out of the bond market, yields will increase, and investors will wonder if we are plunging into another recession. Most likely what will happen is that after a few months of speculation, claims that the sky is falling, and mayhem, things will return to normal (barring other outside factors).
Should You Fear the Taper Tantrum?
The answer to whether or not you should fear the Taper Tantrum is: that depends. No matter what happens, the market is going to react to an increase in the prime rate. Those trying to get loans won’t be happy that they are getting locked into a higher interest rate, and the bond market will see large fluctuations in prices and yields. However, your individual portfolio will depend on how you are invested, and what your goals may be.
If you plan to retire in the next year or so, then now is a good time to worry about the Taper Tantrum. Since it is such a complicated subject, containing a number of variables, you should sit down with your financial advisor and develop a plan for riding out the storm without losing all your money. It may be in your best interest to pull away from bonds for a while (or at least have enough outside that you don’t have to sell them off when the prices are down).
If you don’t plan to retire any time soon (or you don’t need to dip into your investments) then you really have nothing to worry about. In fact, small market downturns are good for those with plenty of time before they need the funds because they can purchase more shares at a lower price.
The Bottom Line
This Taper Tantrum may not even come to fruition. If the Fed can figure out a way to raise interest rates and mitigate the effects, the tantrum will barely be felt. But the likelihood of that is rather small.
Your best bet is to keep an eye on the way things are going, have a solid plan of what to do, and act quickly when it does. But avoid investing on emotion; you almost always lose in those cases.