Since early last summer, the US Federal Reserve has been talking about tapering.

In order to support the economy during the pandemic, America’s central bank has been keeping longer-term interest rates artificially low by purchasing US Treasury bonds and mortgage-backed securities to the tune of $120 billion a month, a process known as quantitative easing, or QE.

Reducing the monthly amount of those purchases, or “tapering”, is now expected to begin before the end of the year.

The second half of September saw heightened-risk market volatility in reaction to prospects of slower economic growth, troubles in China and the likelihood of Fed tapering.

Investors need now consider the implications of an imminent monetary policy shift and how securities prices may be further impacted in the months ahead.

While QE and other aggressive central bank policies were deemed necessary in 2020 to contain the fallout from Covid, the economy has since picked up considerable steam and a reversal of those policies is now warranted.

Besides attempting to boost overall employment, the Fed must also consider the rising tide of inflation. Higher interest rates have traditionally been used as a tool to keep consumer prices in check.

In late September, we caught a glimpse of what may lie ahead when the S&P 500 index plunging almost 2 per cent on Monday, September 20 — one of its largest declines so far this year.

Although the drop was largely attributed to the financial crisis surrounding the China Evergrande Group, the Fed tapering narrative did not help. Longer-term bond prices were also bashed that week as interest rates climbed to recent new highs. Last month, the ten-year Treasury yield rose by about 21 basis points from 1.28 per cent to 1.49 per cent.

Rising long-term bond yields also contributed to sloppy equity markets in September.

The MSCI (Morgan Stanley Capital International) world stock index declined by 4.29 per cent and the S&P 500 fell 4.76 per cent during the period.

Notably, the Russell 1000 value index outperformed the Russell 1000 growth index by 201 basis points for the month as investors rotated from growth to value stocks. Growth stocks in sectors such as technology and healthcare are inherently more sensitive to interest rates.

Under the theory that stock prices represent the discounted net present value of future cash flows, growth stocks become mathematically less valuable in a rising-rate environment where their intrinsic value is more heavily weighted towards expected earnings streams farther out.

Easy money is generally good for both stocks and bonds but when the Fed begins to withdraw stimulus from the system, securities prices can suffer. The term “taper tantrum” refers to the 2013 reactionary panic which triggered a spike in US Treasury yields and a decline in the stock market after investors learnt that the Fed was slowly putting the brakes on its QE programme.

The 2013 tantrum began under former Fed chief Ben Bernanke when he tipped the committee’s intentions during an appearance before Congress in May of that year.

From May through late August of 2013, longer-term interest rates rose more than 100 basis points while the stock market plunged about 5 per cent before resuming its upward trajectory later in the year.

Expect greater market volatility during the months ahead. Readers of this column know we keep an eye on the CBOE Volatility Index, or VIX.

Market drawdowns such as we saw late last month are typically accompanied by spikes in the VIX.

After averaging just above 20 during the past 12 months, the volatility index jumped to 25 on the day of the market’s recent sell-off. More frequent spikes and higher average volatility measures should be anticipated as the Fed begins withdrawing liquidity from the system rather than just talking about it.

Perhaps the greatest difference between 2013 and now is how much less room the Fed has to manoeuvre.

Thanks to its unconstrained spending initiatives and lack of fiscal accountability, US government debt has ballooned to about $28.43 trillion, almost doubling since 2013 when it was estimated at $16.7 trillion.

Given these burdensome debt levels, each uptick in interest rates increases America’s debt-servicing costs exponentially and places further pressure on future spending plans. With so much debt outstanding, the Fed can only afford to raise interest rates by a much smaller amount this time around.

Another near-term constraint on monetary policy is political. Fed chairman Jerome Powell is up for reappointment next February. To retain his position, he is unlikely to make any dramatic moves which could jeopardise his standing. The Powell Fed is more likely to make measured and well-broadcast moves designed not to roil the markets.

For these reasons, we might consider this a period of “taper testing” rather than a full-blown “taper tantrum” as we saw in 2013.

The testing component comes about as we are truly in uncharted territory with respect to government debt levels. The Federal Open Market Comittee will reserve the right to interrupt its tapering initiatives if financial markets begin to behave badly.

While tapering will likely commence this year, an increase in the federal funds rate will be farther off.

After the September FOMC meeting, the committee’s so-called dot plot, which the central bank uses to signal its outlook for the path of interest rates, shows that officials are now evenly split on whether it will be appropriate to begin raising the federal funds rate next year. The median projection in its latest plot indicated no rate increases until 2023.

With short-term interest rates set near zero, conservative investors parked in money market funds or bank deposits will have to wait longer for good news. In this environment, it may be tempting to take more risk by moving out the interest-rate curve to obtain higher yields.

In fixed income, we currently favour higher coupon issues trading to short-term call dates. Equity investors should strike a balance between growth and value.

Bryan Dooley CFA is head of portfolio management at LOM Asset Management Ltd in Bermuda. Contact LOM on 441-292-5000 for further information. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult their brokers if such information and/or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.