The Federal Reserve announced the beginning of its tapering process earlier this month. This marks a reduction to a period of historic monetary stimulus to prop up the economy from Covid recession. As tapering starts and interest rate hike nears, we believe it is right to increase our exposure to the financial sector, especially the money-center banks. Recently, we've cut PayPal (a fin-tech play with more emphasis on the tech), added to our positions in Wells Fargo (WFC), Morgan Stanley (MS) and initiated a new name - JPMorgan (JPM).

What Is Tapering?

When central banks buy securities (bonds) from member banks (12 Fed banks), they are actually pouring money into the economy. This means the Fed is trying to increase the money supply, which makes money more plentiful and drives down the price of borrowing. Such asset buying along with maintaining low interest rates is called quantitative easing (QE). When the Fed believes that the economy has recovered sufficiently, they start to wind down asset purchases. This process is called tapering. Once tapering completes, the Fed is no longer "printing money." The next move is to do quantitative tightening (QT) - essentially raising interest rates. 

How Does The Market React To Tapering? Comparing Bond Markets' Reactions In 2013 And 2021

In 2013, when Federal Reserve chair Ben Bernanke announced that it would taper the bond-purchase program at some time in the future, investors reacted negatively by selling their bonds. Bond prices decreased and yield increased as these two figures move inversely. The sharp climb in yield is referred to as the “taper tantrum”. After the massive sell-off, the market continued to rally later as the economy can stand firmly on its own.

In late July 2021, Federal Reserve chair Jerome Powell signaled that the Fed would start decreasing the amount of its bond purchases later in the year. The reaction of the market was different this time; or for lack of a better word, there was no reaction. This is because market now knows about how QE and tapering work, and have been able to price this in.

Some version of this comparison was written in summer here.

Interest Rates and Financial Sector

When a company is less profitable—either through higher debt expenses or less revenue—the estimated amount of future cash flows will drop, leading to a sell off in the stock. However, some sectors stand to benefit from interest rate hikes, and one that stands to benefit the most is the financial sector. Bank earnings often increase as interest rates move higher because they can charge more for lending.

Currently, the 10-year Treasury yield is around 1.5%. We would expect this rate to be around 1.8% by early next year. Although the Fed says that the bond-purchasing program would not implicitly mean raising interest rates, interest rates will gradually increase next year because there is a firm connection between money supply and interest rates. We believe that the financial sector should perform well when there is less volatility in the market (especially the mid 2022 and early 2023 when interest rate hikes).