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Explainer: A Visual Introduction to Fed Tapering

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Fed Tapering

Fed Tapering

Explainer: A Visual Introduction to Fed Tapering

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The Federal Reserve began tapering its large-scale asset purchases in November 2021, a move likely influenced by:

  • Rising inflation
  • Improving unemployment
  • Strong U.S. GDP growth

More than $4 trillion in capital was injected into the economy through quantitative easing (QE), over the course of the pandemic, inflation is at 40-year highs, and unemployment levels hover below 4%.

As Fed policy responds to a recovering U.S. economy, this Markets in a Minute chart from New York Life Investments shows how Fed tapering works, and its impact on the economy.

How Fed Tapering Works

Fed tapering is the unwinding of the Federal Reserve’s large-scale asset purchases.

After the 2008 financial crisis, large scale asset purchases were introduced for the first time to inject liquidity into the market and help restore confidence. During the pandemic, they were introduced once more, at a rate of $120 billion per month.

Here’s how it works:

  1. The U.S. central bank buys government bonds typically in the form of Treasuries and mortgage-backed securities (MBS).
  2. This influx of demand leads to a rise in these bond prices and their yields (interest rates) fall.
  3. As this lowers the interest rate on the government bonds, what often follows is lower interest rates on loans for households and businesses.
  4. Lower rates stimulate spending.
  5. When the economy is running well, the bank may unwind asset purchases to help keep inflation low, otherwise known as Fed tapering.
  6. Notably, Fed tapering and QE is hotly debated among economists. Those in favor say QE is a critical tool for stimulating the economy. Those against say that it inflates asset prices and contributes to inequality.

    Inflation Levels

    The consumer price index (CPI) rose 7% in December, the highest rise since 1982.
    Fed Tapering

    Given this increase, Lawrence Summers, former U.S. Treasury Secretary and Jason Furman, former chief economist for President Obama say that the Fed didn’t taper soon enough. Other financial heavyweights suggest this is just the beginning of a hawkish approach to inflation.

    So how does Fed tapering impact inflation?

    By tapering asset purchases, the amount of money circulating in the economy that can be used to borrow to buy a house or car is reduced. According to this theory, when there is less spending, inflation will gradually cool down.

    Fed Tapering and Interest Rates

    The Federal Reserve has outlined that it will taper asset purchases before it increases targets on short-term interest rates. By current estimates, interest rates could rise in March.

    However, if the pandemic takes a turn for the worse, the Federal Reserve can shift direction. This gives the Fed time to assess how the market and economy will react before it raises rates.

    To prevent the taper tantrum of 2013, which led to market volatility and U.S. dollar appreciation, Federal Reserve chair Jerome Powell has stated that the Fed must carefully communicate the sequence of QE and tapering to prevent any fear in the market.

    When Doves Cry

    Like the 1940s, the rise in money growth over the pandemic has been driven by government deficits. By contrast, leading up to the 2008 Global Financial Crisis or during the 1950s and 60s, the private sector spurred loan growth.

    Monetary inflation can impact consumer prices and financial asset inflation.

    As CPI and financial markets have soared over the pandemic, investors will be watching closely to see how Fed tapering impacts future monetary policy.

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Markets in a Minute

Identifying Trends With the Relative Strength Index

When is the S&P 500 Index considered overbought or oversold? The relative strength index may offer some answers to identifying market trends.

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Identifying Market Trends: The Relative Strength Index

What happens when the S&P 500 Index enters oversold territory? Does the market reverse, or continue on this trend?

A widely-used momentum indicator, the relative strength index (RSI) may offer some insight. The RSI is an indicator that may show when a stock or index is overbought or oversold during a specific period of time, indicating a potential buying opportunity.

This Markets in a Minute from New York Life Investments looks at the RSI of the S&P 500 Index over the last three decades to show how the market performed after different periods of overbought or oversold conditions

What is the Relative Strength Index?

The RSI measures the scale of price movements of a stock or index. In short, the RSI is used to calculate the average gains of a stock divided by the average losses over a certain time period. These are then tracked across a scale of 0 to 100. Broadly speaking, a stock is considered overbought if it reads 70 or above and it is considered oversold if it is 30 or below.

For example, when the S&P 500 Index has a RSI of 85, an investor may consider it overbought and sell their shares. Conversely, if the RSI hits 25, an investor may buy the S&P 500 thinking the market will bounce back.

The RSI is often used with other indicators to identify market trends.

The Relative Strength Index and S&P 500 Returns

Below, we show the 12-month returns of the S&P 500 Index after key ‘overbought’ or ‘oversold’ conditions in the market as indicated by the RSI:

DateRSIShiller PE Ratio*S&P 500 Index 12-Month Return
Jul 15 200220239.4%
Dec 4 200673274.5%
Oct 13 200815167.3%
Feb 7 201175231.9%
May 13 2013752316.1%
Jan 8 20188933-7.2%
Mar 16 2020222566.3%
May 3 202172370.0%

*Measured by the average inflation-adjusted earnings of the S&P over 10 years

As the above table shows, following each period of extremely oversold territory in the RSI, the S&P 500 Index had positive returns.

In fact, the S&P 500 Index had the strongest one-year returns following the COVID-19 crisis of March 2020, with over 66% 12-month returns. During the time of extreme fear, the RSI sank to deeply oversold territory before sharply rebounding.

Interestingly, following periods of extremely overbought conditions in the market there was a range of positive and negative performance. Most recently, before the peak of the last cycle in 2021, the S&P 500 Index spent roughly 9 months in ‘overbought’ territory before declining into 2022.

The Relative Strength Index in 2022

With the economy in uncertain territory, how does the RSI look today?

In early June, following a bleak consumer sentiment announcement, the RSI fell to 30, hovering on oversold territory. Since then, it has risen closer to 40 as consumer sentiment and perspectives on economic conditions have slightly improved.

However, whether or not the RSI will continue on this uptrend remains to be seen.

For the remainder of 2022, market sentiment, which may be shaped by the coming GDP and inflation figures, could push RSI into oversold territory once again. As a bright spot this may be good news—reinforcing a turning point in the market.

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Markets in a Minute

Visualized: How Bonds Help Reduce Bear Market Risk

How have bonds historically performed during a bear market? How have different stock and bond allocations performed?

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Bear Market Risk

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Visualized: How Bonds Help Reduce Bear Market Risk

Which tactics can investors use to reduce portfolio downside risk?

One time-tested method is allocating to bonds. Bonds have sheltered portfolio losses during bear markets thanks to the lower risk profile of bonds compared to stocks. Often, when stocks declined during market selloffs, safer assets like bonds tended to increase as the demand for stability grew.

This Markets in a Minute from New York Life Investments shows the performance of bonds and stocks during bear markets since World War II.

Bond Performance During Bear Markets

Bear markets are defined as a 20% or more decline in U.S. large cap stocks from peak to trough. Since World War II, bear markets have occurred less frequently than bull markets, with the U.S. stock market spending 29% in a bear market versus 71% in a bull market.

With this in mind, we show how a spectrum of portfolio asset allocations to stocks and bonds have performed over the last several bear markets.

  • Stocks: represented by U.S. large cap stocks
  • Bonds: represented by U.S. intermediate government bonds, which are issued with maturity dates between two and five years
Allocation (Stock / Bond)Average DrawdownAverage Time Until Recovery*
100% / 0%-34%3.3 years
90% / 10%-31%3.2 years
80% / 20%-28%2.9 years
70% / 30%-24%2.8 years
60% / 40%-20%2.5 years
50% / 50%-16%2.1 years
40% / 60%-11%1.2 years
30% / 70%-7%0.8 years
20% / 80%-4%0.8 years
10% / 90%-2%0.5 years
0% / 100%-1%0.2 years

*Length of time until new all-time high

For a 100% stock portfolio, the average drawdown was -34%, with 3.3 years until recovery—the time it took to reach a new all-time high.

Comparatively, a portfolio entirely made up of bonds fell -1% on average during bear markets with a recovery time of just a few months.

Balanced Portfolios in Bear Markets

Looking closer, we show how adding bonds to a portfolio has cushioned portfolio losses over the following market downturns, sometimes by as much as 20 percentage points.

Bear Market100% Stock Portfolio Max Drawdown60/40 Portfolio Max Drawdown
2020-20%-10%
2008-51%-30%
2001-45%-22%
1988-30%-17%
1973-43%-26%
1969-29%-18%
1962-22%-13%
1947-22%-13%

A balanced 60/40 portfolio had a 20% average drawdown, recovering in 2.5 years. During the 2020 COVID-19 crash, for instance, a 60/40 portfolio fell almost 10% and fully recovered in six months. By contrast, a 100% stock portfolio declined nearly 20%.

In all of the above historical downturns, investors with a diversified portfolio have been better positioned in a bear market.

Building Portfolio Strength

Bonds have historically seen less volatility than stocks during tougher financial conditions. Typically, riskier assets like stocks have been more prone to market fluctuations than bonds.

To prepare for a bear market, investors can structure a portfolio that aligns with their risk tolerance. Over the long run, the diversification benefits of bonds have been fundamental to protecting portfolios and lowering risk.

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