After the Fed’s great unwind begins, the stock market yawns

The first month is in the books for the Federal Reserve’s yearslong process of pulling the plug on its bond-purchase program, and markets took things in stride. It’s a massive undertaking for the Fed, whose investment portfolio swelled to nearly $4.5 trillion. Economists credit the program with helping push U.S. stock funds to returns of more than 300 percent since the spring of 2009. In the past, even the hint of a slowdown in bond purchases sent investors into a “taper tantrum” and caused interest rates to jump. But the stock market calmly set more records in October, as the Fed let $10 billion of Treasurys and mortgage-backed securities in its portfolio mature without reinvesting the cash. The pace will rise to $50 billion per month by the end of next year. The bond market was more exciting than the stock market. The yield on the 10-year Treasury reached its highest level since March as the economy got stronger and investors waited for President Donald Trump’s choice for the next Fed chair. A lot is riding on whether markets can remain calm. If rates rise faster than expected, say as a result of a burst of inflation, markets could get upset. A jump in rates would make stocks less attractive. While stocks look unusually expensive based on company profits, they look better compared to the small interest payments from bonds. Higher rates could change that, and it would also leave bond fund investors with losses on what are supposed to be the safe parts of their portfolios. Here are several reasons why analysts say the market has been so calm about the Fed’s balance-sheet moves so far: — Since the 2013 “taper tantrum,” the central bank has gone to great lengths to telegraph its moves. With President Trump tapping Jerome “Jay” Powell to be the next chair of the Fed, economists expect this to continue. They say he is less aggressive about raising interest rates than other candidates and should stick with the current Chair Janet Yellen’s plans, reducing the Fed’s balance sheet and gradually raising short-term interest rates. — The economy is better able to stand on its own and other economies around the world are hitting a higher gear. It’s a much different picture than when the Fed was buying bonds following the Great Recession and the cumulative effect of all that aid for the economy means financial conditions are still relatively easy. “The Fed has so overdone it for so many years, they’ve taken monetary policy so far out of bounds, that they may have to tighten for a while before they get back inbounds,” said Jim Paulsen, chief investment strategist at the Leuthold Group. — Other central banks are still pumping lots of stimulus into the global economy. The European Central Bank buys 60 billion euros of bonds each month, though it plans to reduce those purchases to 30 billion euros in January. The Bank of Japan is buying government bonds and other assets to support its economy. So, what could upset the market? Inflation pressures may be rising. With the economy in a healthier position, additional stimulus such as tax cuts could heat up the economy even more and cause prices to jump. If that were to happen, the Fed may find itself forced to raise interest rates more quickly than expected. “I think the market is underpricing the potential for inflation going higher,” said Schroders investment strategist Jon Mackay. “We could have a shot to the system, and if that happens, the equity market would have to take a breather.”