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Fed "tapering": Good for long-term investors

December 19, 2013

Many market pundits predict the stock market rally will sputter now that the Federal Reserve has announced it will begin paring back its quantitative easing (QE) program. While the future remains uncertain, Vanguard believes that "tapering" largely represents positive news for long-term investors because it's a sign monetary policymakers view the U.S. economy as being on more solid footing.

Prepare for potential volatility

Quantitative easing refers to the government purchase of securities, including Treasury bonds and mortgage-backed securities, in an effort to affect monetary conditions in an environment of near-zero policy rates.

Tapering refers to a gradual reduction in the monthly purchase of these assets by the Federal Reserve.

Despite the economic improvement that the Fed's policy decision represents, the path to unwinding QE is likely to be rocky at times.

"The extraordinary measures undertaken by the Fed and other central banks in response to the financial crisis have left us in uncharted territory," explained Andrew Patterson, investment analyst in Vanguard Investment Strategy Group. "High levels of uncertainty around the unwinding process of an unprecedented level of stimulus increase the likelihood of volatility."

Andrew PattersonDespite taper plans, the Fed will maintain flexibility to respond to changes in the economy, including increasing asset purchases if economic conditions warrant.

Tapering does not equal tightening

Tapering does not indicate that interest rate increases are imminent. In fact, although the first round of tapering has been initiated, there is no set timetable for policy action. Tapering means the Fed will still purchase assets, but not as much. By contrast, a tightening of policy—from the Fed's perspective—does not occur until the Fed's balance sheet shrinks and, soon after, short-term policy rates start increasing.

"Tightening is not likely until early to mid-2015," Patterson said. "And the risk may actually lean toward the Fed's keeping short-term rates near zero percent even longer."

When Fed policy does shift to tightening, the transition is expected to be gradual.

"Once initial tapering has begun, the road to normalized policy is likely to be long and volatile," Patterson said. "It is not particularly clear as to just what normal policy will look like. The Fed has addressed an unprecedented crisis with unprecedented policy-easing measures, and the tools for unwinding this extraordinary policy are untested."

Clients should focus on what is in their control

While the market has fixated on Fed action, no one can predict with certainty how the QE exit strategy will play out. Yields have risen sharply this year on speculation of Fed tapering, and, given that they are still at historically low levels, rates are likely to go higher. However, when interest rates will rise, how fast interest rates will increase, or how the shape of the yield curve or credit spreads will evolve remain uncertain. Without knowing those variables, any outlook would amount to only an educated guess at best.

Vanguard believes the smart choice for investors is to stick with the course of action that has historically served them well through changing market conditions: Stay diversified. While the appetite for high-quality* bonds, such as U.S. Treasuries, has waned because of muted return expectations, bonds still offer important diversification benefits with the potential to offset equity risk.

We encourage investors to look past the short-term noise and refocus on factors that will help them achieve their goals and are within their control: balance, cost, and discipline.

*High-quality bonds include U.S. Treasuries and other fixed income securities with a credit rating of Baa3 or higher by Moody's or a credit rating of BBB- or higher by Standard & Poor's or Fitch.

Notes:

  • All investing is subject to risk, including possible loss of the money you invest. Past performance is no guarantee of future returns. Diversification does not ensure a profit or protect against a loss.
  • Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.
  • While U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.
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