This major threat to global stock markets has just been removed

A ‘taper tantrum’ ranked alongside inflation as the main tail risks for investors, but the latest US central bank decision has been warmly welcomed by investors. Here’s why.

A taper tantrum had been one of Wall Street's biggest fears this summer, but as it turned out the Federal Reserve's move to start scaling back economic stimulus barely raised a murmur.

The US stock market shrugged its shoulders before closing at fresh records, no doubt buoyed by accompanying signals from the Fed that interest rate rises remain a long way off.

While the unwinding of post-pandemic support is only just beginning, the Federal Reserve chair Jay Powell deserves credit for the way that market expectations have been managed to the point that last night's announcement ended up causing so little fuss.

The Fed is likely to have heeded the lessons from 2013 when stock markets went into panic mode after policymakers placed the brakes on quantitative easing. Worries over a repeat this year were highlighted in Bank of America's June survey of fund managers, which listed a taper tantrum alongside inflation as the main tail risks for investors.

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The jitters had been on show a few weeks earlier when the benchmark US bond yield peaked at almost 1.8%, but since then there's been wide-scale Wall Street acceptance of the Federal Reserve message that inflationary pressures should be transitory.

Such a relaxed view has done no harm to the TINA effect — There Is No Alternative — where shares remain attractive due to poor returns on cash and government bonds, driving the S&P 500 and tech-laden Nasdaq to fresh records this week as a result. 

Tellingly, the 10-year yield only rose to 1.6% last night. That's a positive for high-growth stocks such as those in the tech sector, where valuations are built on future strong cash flows and are vulnerable to a rising bond yield.

The yield is likely to firm as the Fed progresses with its tapering programme and moves closer to a first hike in interest rates. Unlike the Bank of England, where a move to 0.25% is expected soon, Powell is convinced there's no need to change the course of monetary policy.

He believes elevated inflation shouldn't be persistent and will return towards the Fed’s long-term goal as supply bottlenecks ease and Covid-19 becomes less of a factor.

Wall Street continues to price in a first rate rise in the third quarter of 2022, with two hikes over the course of the year. That's in contrast with the Bank of England, where the guidance is for imminent hikes as inflation heads towards 5% and stays above the 2% target level.

UBS analyst Paul Donovan wonders if the Federal Reserve needs to take a closer look at what is happening to core monthly inflation. He said today: “Powell seems to reference year-on-year inflation, which is fine apart from the fact that last year’s inflation was of dubious quality. Consumers do not think in year-on-year terms.”

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For now, the Federal Reserve is satisfied that reducing its $120 billion bond purchase programme is sufficient. Since embarking on the support in March 2020 it has almost doubled the size of its balance sheet to $8.6 trillion following the purchase of Treasuries and housing-backed securities.

It will reduce the monthly buying by $15 billion in both November and December before winding down the process entirely by next summer.