There has been a lot of media chatter recently about the Fed discussing the dreaded “tapering” process, so I felt like it made sense to go over what this means and why it matters. In response to the economic impacts of COVID-19, the Federal Reserve (the Fed) stepped up and did a few things - which is their job, and overall they for sure cushioned the blow, giving the economy a soft landing and a springboard to get back on track. 

To fund these cushions and springboards, the Fed has been buying around $80 billion worth of Treasury securities and $40 billion of agency mortgage-backed securities (MBS) each month. The “tapering” you’ve been hearing so much about is simply referring to slowing the pace of the Fed’s large scale asset purchasing program. In other words, buying those Treasury securities and MBS’s could slow down if the economy continues to gain strength. In even simpler terms, once these HUGE policies have done their job of helping the economy rebound, at some point they have to go away, which is what this tapering is all about. But if it were that simple, I wouldn’t be writing this newsletter about it, so as you probably guessed, this is where the problems begin…

Let’s imagine this in a more entertaining light for a minute. It's Sunday morning and you go into a random fraternity house and see the carnage from the night before. The place is a disaster, and everyone is hungover. You decide you want to help the boys get going again, so you grab a big cooler and fill it up with some classic red Kool-Aid to nurse their hangovers, help the situation, and get everything in the Frat house back to normal.

An hour later, you do see a little improvement but not the full desired effect. The boys are asking what else you can give them to help, and you remember you have a bunch of vodka in your trunk. So you add the vodka to the Kool-Aid and an hour later, this has drastically improved morale. So you add some more vodka because more is better, right? Let's fast forward several hours - things are pretty much back to normal, everyone is feeling good and the party’s started again. So you start to say your goodbyes and let the guys know that you’re heading out - along with your Kool-Aid and vodka.

Obviously this is not what they want to hear, and chaos ensues. On a really basic level that's not too dissimilar to what's going on now. Wall Street loves loves the Fed pumping liquidity into the economy, and they get used to it and don't want it to ever go away. This was a big problem coming out of the financial crisis because up to that point the Fed had never been this involved. 

Now this Kool-Aid effect is not just a domestic issue. Every major central bank in the world does this. The whole effect that central banks are going for is to keep interest rates low. If they are buying up all these bonds, then there are less available to purchase, so the prices will go up, and the yields will go down, thus causing interest rates to go down and making money cheaper to attain. The theory is that the cheaper money is to get, the easier it is for businesses to borrow money to finance new projects, which will keep employment up. Again, the tricky part is when to step away and wind down this “Kool-Aid-vodka” gesture. If you stop too early, the economy could falter and slide back into a recession. If you don’t stop soon enough, we could have an inflation problem. 

At the end of the day, tapering the asset purchases by the Fed is necessary and not stopping would actually be super harmful in the long run (imagine if the Frat never put down their red solo cups), but Wall Street doesn't want to hear that noise. They care about today. If interest rates go up, that immediately affects bottom lines, ESPECIALLY with Corporate America’s debt levels right now. The Fed has been pumping billions upon billions into the economy and a lot of that has been funnelled right back into the equity market, pushing equities to all-time highs on almost a daily basis. At some point, you just have to take away the vodka because you know the fraternity isn't going to stop on their own and they will just end up back at the same place they were on Sunday morning.

Join us Wednesday, September 15th at 12:30PM CT to take a deeper dive into this topic. See you then! 

Sean McDougle, CFP®