The Federal Reserve Taper Begin

The Federal Reserve Board has made its long-awaited announcement that it will begin to scale back ("taper," in Wall Street language) its QE3 stimulus program.  The last time the Fed even mentioned starting to taper back, last fall, global stock markets and bond investors panicked and sent the markets reeling.  Now, the Fed says that instead of buying $85 billion in Treasuries and mortgage bonds per month, it will only buy $75 billion, and more cuts will come as the economy continues its recovery and the jobless rate continues to fall. 

With this announcement, markets went up and investors cheered.  Japan's Nikkei index reached a six-year high, European markets soared and U.S. stocks finished the day at new record prices.

Does any of this make sense to you?

The so-called "taper," and the QE3 stimulus program itself, are somewhat unique in the history of investment markets.  To understand QE3, imagine that at the auctions where investors buy government bonds and packages of home loans, a bidder nine times the size of Gargantua shoulders everybody else aside and insists on paying higher prices (and, therefore, receiving lower interest) than any of the other bidders.  The Fed's stated goal was to stimulate the economy by driving interest rates lower, making it less expensive for large and small businesses to borrow money, so they can build factories, expand their capacity and hire more people.

The problem with this stimulus effort was two fold:

1. Many American corporations were already sitting on tons of cash, and have little need to borrow if they really wanted to go on a building and hiring spree.  The companies in the S&P 500 index reportedly have a record $1.5 trillion in their coffers, up 14% this year alone.  Add in the money stuffed under the mattresses of some smaller companies, and the total may exceed $5 trillion. 

2. The Fed kept interest rates so low that banks did not want to loan money to small businesses and/or people who did want loans.

The Fed's mortgage purchases probably did make mortgage rates a bit cheaper for home buyers, but it's hard to tell how much.  The day after the announcement, 30-year Fannie Mae mortgage rates were up 0.01 percentage point, at 4.42%.  That's higher than the low of 3.31% in November of 2012, but still very low by historical standards.

Savers and long-term investors should breathe a sigh of relief that the Fed is finally easing out of the investment business.  Why?  For one thing, it means that economists at the Federal Reserve Board believe the economy is finally in a self-sustaining recovery mode. 

For another, it means the end of uncertainty.  When investors are unsure what to expect, they tend to expect the worst. Which is why you will read articles saying that the taper could cause interest rates to skyrocket leading to some problems with the value of ETF & mutual fund bond investments currently owned by investors. But admittedly by early indications, no such thing is happening right now, and you can bet that Fed economists are monitoring the situation and will try to nip any such problems in the bud.

At the same time, we can expect interest rates to go up over the next few years. This could be a problem for some bond ETF or mutual fund holders, but it is great news for older Americans who have been living on CD interest rates that are barely higher than what they would get if they stashed their retirement money in a cookie jar. 

For the economy as a whole, there is still plenty of cash to lend to any company that wants it if it becomes profitable to do so, housing is still more affordable than it was before the 2008 meltdown, and inflation is still currently stubbornly lower than the government's preferred target rate. All in all we are ending 2013 on a great note. However, I will personally be moving into 2014 with a little caution.