Tapering is a term used in finance to describe a reduction of monetary stimulus provided by central authorities to the capital markets.
In times of weak economic growth or extraordinary stress, such accommodative monetary stimulus may have been implemented in the form of low policy rates, looser regulatory ratios, or most commonly, large-scale asset purchases in the secondary markets. These asset purchases are frequently seen in quantitative easing (“QE”) policies whereby central banks look to inject liquidity directly into fixed income markets in order to drive yields lower and reduce the overall cost of borrowing. QE purchases in equities and ETFs, on the other hand, are not just meant to reassure markets but make investors move out of these assets into other risk assets, such as emerging markets, loans, and real estate.
Bloated Balance Sheets For The Central Banks
However, such purchases have led to bloated balance sheets for the central banks that have undertaken QE. For example, the Federal Reserve (“Fed”), the central bank of the United States, has seen its balance sheet grow from $900 billion to almost $9 trillion in the 13 years from 2008 to 2021, as it looked to provide economic stimulus in the aftermath of the 2008 global financial crisis and COVID-19. At its height, the Fed was spending about $120bn each month, mostly purchasing US Treasury Securities and Mortgage-Backed Securities (“MBS)”. Hence, as central banks look to start tapering, they must send the right signals to investors and the markets in order to set market expectations and reduce uncertainty.
On the other side, as central banks like the Fed look to taper, the capital markets closely follow when and how the process will look like. In the US, Federal Reserve Board Chairman Jerome Powell indicated in August 2021 that the Fed is likely to begin tapering before the end of 2021 as part of his annual Jackson Hole speech. While rate hikes would certainly be part of the tapering process eventually, most market watchers believe that the Fed will start with its roughly $120bn worth of asset purchases being reduced each month until the end of 2021 provided that the economy continues to improve and inflation stays in check.
Why Do Investors Care So Much About Taperings?
While the reduction in asset purchases will have a direct impact on the prices or yields of those assets, the bigger implication is what it signifies for the timing of the Federal Reserve hiking policy rates. These tapering announcements have typically resulted in sharp rises in government bond yields, yield curve distortions, and equity market sell-offs. Hence, policymakers are very careful about the timing, pace, and scale of tapering plans.
A recent example of tapering can be seen in the US at the Fed after the 2008 global financial crisis. In June 2013, Ben Bernanke, the Federal Reserve Board Chairman at the time, announced that the Fed would begin tapering and reduce the amount of its asset purchases. Then in January of 2014, the Fed started tapering by $10bn per month from $85bn to $75bn, with the intent of ending the QE program around the middle of 2014. Stock markets fell, US domestic interest rates rose and risky assets, such as Emerging Market debt and equity weakened.