Taper Timing: Preparing for the Fed’s Next Move

Investors have been focusing a lot on economic data lately, not least because signs of sustained economic strength or higher-than-expected inflation could potentially spur the Federal Reserve to move up its timing on tapering asset purchases and raising interest rates.

More market participants now anticipate the likelihood of more aggressive Fed moves to scale back its accommodative policies enacted after the pandemic-induced global market crash in March, 2020, and the deep recession that followed. With some members of the central bank recently offering competing timelines on when to start tapering, the Fed’s annual Economic Policy Symposium in Jackson Hole, Wyo., at the end of August has taken on greater importance.

Yet, it seems that the possibility of a policy shift hasn’t sunk in for some investors in more vulnerable corners of the market: namely, longer-term Treasuries, mega-capitalization growth stocks and the passive S&P 500 Index funds that are heavily anchored to them. These sectors appear at risk mainly due to overextended valuations tied to today’s near-zero interest rates. Any uptick in rates could put downward pressure on these asset classes. And based on recent data, that uptick may be closer than it might seem. 

For one, the employment picture has improved. July’s U.S. jobs report was stellar, with the monthly addition of nearly 950,000 new hirings, on top of the prior two months’ positive revisions. Labor-force participation also grew, and the unemployment rate fell a half-percentage point to 5.4%. The pandemic may have temporarily held back some individuals from returning to work, but we expect such obstacles to clear over the next two to three months, as schools re-open and vaccination rates continue to rise. In fact, Morgan Stanley & Co. Chief U.S. Economist Ellen Zentner recently forecast that the unemployment rate could fall to 3.3% by December 2022, below pre-crisis levels.

In addition, inflation remains elevated. The Fed has consistently described rising prices as transitory and largely due to short-term global supply-chain imbalances. But we view inflationary pressures as more durable. To wit, July’s headline U.S. Consumer Price Index reading showed prices rose 5.4%, compared with a year ago, a 30-year high. The trailing 2-year average is 3.2%, and 3- and 5-year averages remain above 2.2%. These figures are higher than the Fed’s historical inflation target of 2%, and higher even when considering that the Fed’s new framework of a “flexible average inflation target” would allow for inflation to run modestly higher than 2%.

The Fed has had good reason for policy patience, given the unique challenges of the pandemic. That approach, in the meantime, has rewarded investors in U.S. stocks and bonds handsomely, and also perhaps gotten markets used to Fed assurances that it will remain patient on any policy-guidance shifts.

The latest data reflecting a clear recovery in both employment and inflation, however, suggest that the U.S. economy may be operating above pre-COVID levels. As a result, the Fed has started to telegraph a move away from maximum accommodation. When rates move higher, long-term bond prices will decline, given their inverse relationship.

Higher rates can also hurt growth stocks because they effectively lower the value of future earnings. Investors who currently own these assets, or passive index funds that have significant exposure to them, may want to consider taking profits and redeploying cash into high-quality, fairly valued stocks of companies that are tied to economic growth and have the potential to grow their dividends. 

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from August 16, 2021, "Waitin’ on the Fed." Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.