If you’ve been anywhere remotely near the financial industry in the last several months, you’ve probably heard the hustle and bustle on the Fed and its plans to implement tightening. But what exactly is tightening, what is the Fed, what are they trying to achieve, and how will this actually affect investors?

What is tightening?

Quantitative tightening is a term used to describe one of the ways central banks create monetary policy. In order to understand quantitative tightening, we must first circle back to the beginning of the COVID-19 pandemic. During the height of the pandemic in early 2020, the United States’ central bank, also known as the Federal Reserve or “the Fed,” implemented what is known as quantitative easing. Quantitative easing is the opposite of quantitative tightening and is used by central banks to foster economic sustainability during a potential recession. By providing government stimulus and bond-buying programs, the Fed created enough liquidity to keep the economy going to avoid what could have been a severe recession as a result of a global pandemic.

However, now as inflation is rising to record highs, this is signalling that the economy is overheating. As a result, the Fed must take measures to curb this by implementing tapering, or the gradual decrease of government stimulus spending. Once tapering is set into place, the Fed begins to increase interest rates, which does several things.

How does tightening affect the financial landscape?

Drop in bond prices and returns

With interest rates being higher, investors will likely see bond rates as less attractive. With a significant drop in demand, bond prices will likely suffer, shrinking the potential upside from capital gains.

Increase in the cost of borrowing

Again because of rising interest rates, the cost of borrowing also increases. This causes sourcing capital to become more challenging, making it difficult for growing businesses and/or individuals to obtain funding.

Evolution of the stock market

Relating back to the second effect, when sourcing capital becomes more challenging, companies that were experiencing rapid amounts of growth because of an abundance of capital will now suffer due to the lack of funding. Therefore, the stock market will experience a significant shift in which companies receive more capital.

How should investors respond to tightening and its effects?

So now that we are aware of what tightening is and what it does, what does this mean practically for investors? How should we position our portfolios to provide leverage against potential adverse effects? How do we respond to the changing economic environment amidst the Fed’s change in monetary policy?

Cash for Liquidity

During times of uncertainty or change, cash provides investors with both stability and flexibility. While the stock market goes through a turbulent phase, cash provides stability to an investor’s portfolio, with the flexibility to be nimble, being able to respond to the market’s movements in an agile manner. Investors may consider allocating these funds to money market funds that provide larger returns than savings accounts or time deposits, while still maintaining relatively low risk.

Blue Chip Comeback

During the era of low or negative interest rates, growth stock companies, especially in the new economy and tech sector, enjoyed an influx of capital because investors were seeking higher returns. However, with the interest rate increase, the market shifts in favour of blue-chip companies. As sourcing capital becomes more challenging, investors will start to move away from growth back to big-cap companies that are more established with solid assets and a sound flow of capital. As the valuation of tech and new economy companies increases and becomes more expensive, they become no longer as attractive to purchase. On the other hand, value stock, in this case, blue-chip companies, is what should start to draw investors’ attention as they are now trading below what they are actually worth, creating a high likelihood of an upside. Investing in bluechip or index funds is a good place to start as they allow for diversified holdings within the large-capitalization bracket.

Don’t Buy the Dip

As mentioned earlier, as the Fed implements quantitative tightening, capital will likely flow out of the new economy and technology sectors. While during the brunt of the pandemic, tech and new economy companies’ stock prices spiked incredibly, there will likely be a moderate, if not a significant correction in these industries. Although the drop in valuation may seem to be a signal to buy, it may be wise to first analyze the growth potential of the company in question. The inclination to buy the dip because the stock is “on-sale” should also be paired with an objective analysis of the company’s fundamentals to make sure that what you buy will actually grow.

As the economic terrain continues to shift and change, we as investors can prepare ourselves by being aware of what is happening in the market and how monetary policy affects the financial environment. Although the Fed’s plans for tightening may seem to be shaking up the financial world, there is no need to fear; adjusting our investing strategy and adopting a flexible and nimble approach will prove to provide successful portfolio management.