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2021-01-13 • Updated
Fed’s plans to cut bond-buying sent shivers down investors' spines. Let's find out why.
Some Fed policymakers claimed that they are thinking to cut asset purchases by the end of the year. These days Fed buys bonds at $120 billion a month. However, the most senior central banker Richard Clarida disagreed with them and said that no changes should be made until 2022.
Investors are afraid of the taper tantrum. This phrase describes the market panic and instability after US Treasury yields surged in 2013 after the Fed announced its plans to cut bond-buying or in other words claimed future tapering.
Fed buys bonds to increase the amount of money on the market to allow consumers to spend and businesses to invest more. When the market is flooded with dollars, the USD falls.
When the Fed feeds the economy with money for too long, there are unavoidable consequences. When the bank stops injecting additional money, the market becomes volatile, and even panic can ensue.
Just imagine, since the 2008 financial crisis, the Fed had tripled its balance sheet from $1 trillion to $3 trillion by purchasing almost $2 trillion in Treasury bonds. As a result, the Fed had become one of the world’s biggest buyers.
One day, the Fed said it would cut bond-buying (just shared plans, not made it). Investors were negatively shocked as with reduced Fed purchases bond prices would fall. Bond investors sold bonds, the price of bonds dropped as a result. Of course, falling bond prices always mean higher yields, so yields of US Treasuries rose, the US dollar surged as well, and gold plunged.
Fed officials have claimed that they “learned lessons certainly from six or seven years ago” and tapering of bond-buying would be publicly announced well in advance to avoid a surge in Treasury bond yields. Anyway, keep an eye on Fed's annoucements!
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