Has the Fed ‘put’ been put to bed?
The writer is chief investment strategist at Charles Schwab
Don’t fight the Fed. The saying was popularised by the late Marty Zweig, this author’s first boss and mentor on Wall Street in the 1980s and 1990s. Zweig also coined the phrase: “Don’t fight the tape”.
The tape — the record of stocks transactions through the day — is decidedly not fighting the US Federal Reserve, with the prospect of monetary policy normalisation clearly behind a very rocky start to the year for US shares. It is typically a pothole-riddled path that is created when central banks begin to normalise policy — even more so during this anything-but-normal pandemicycle (there’s a new word for you).
Conceding that inflation is not quite a transitory phenomenon, the Fed is now on a mission. The launch point for the Covid-19 tightening cycle is unusual, in part due to what appears to be a much later phase in the cycle for the economy than the calendar might suggest. The post-2020 recession expansion is only 21 months new but the inflation, labour market and asset valuation backdrop is decidedly later-cycle.
Much recent analysis of past tightening cycles have been limited to just the prior three rounds of Fed rate rises, but those only date back to 1999 — an era characterised by secular disinflation and the attendant positive correlation between bond yields and stock prices. It is different this time.
The inflation cat is out of the bag; and arguably, the Fed opened the bag on purpose when, in August 2020, it implemented a more flexible monetary policy strategy. In, short, the Fed has been actively pursuing higher inflation. The aim is to let inflation run hot to compensate for the lengthy era of disinflation.
Another key difference between the current path towards policy normalisation and past episodes is the Fed’s $9tn balance sheet. Markets are perhaps keenly aware of the perceived implications of its quantitative easing programme of bond buying on yields and asset prices; but they have much less experience with pending quantitative tightening.
The plumbing system that connects QE (or QT) to asset prices is indirect and complex. But the psychological system connecting them tends to be more direct. Signals from the Fed about balance sheet plans have been important market drivers — highlighting the power of the Fed’s words, aka jawboning.
Fed officials are now explicitly stating their desire for tighter financial conditions in the interest of moving away from hyper-stimulative policies, squeezing aggregate demand and bringing inflation down. No, imminent rate rises do nothing to solve the semiconductor backlog problem, nor do they bring down the number of container ships sitting off the ports of Long Beach. However, coupled with the Fed’s jawboning, they can arguably change the trajectory of inflation expectations and/or aggregate demand via consumers’ behaviour.
The hope is that both the economy and financial markets can adjust to monetary policy normalisation in an orderly fashion. But here is where things might get tricky. The notion of a “Fed put” has been in and out of play since the Alan Greenspan era; with many market participants believing the central bank will step in if markets begin to riot. Do not count on that in this era.
For now, financial markets are volatile, but functioning properly. The volatility and weakness are occurring alongside the repricing of risk assets — not being driven by any serious deterioration in liquidity conditions or financial system functionality. In fact, the equity market is a component of most indices measuring financial conditions. As such, equity market volatility-induced tightening of financial conditions could arguably be a feature, not a bug, as it relates to prospective Fed decisions.
Back in 2018, Fed chair Jay Powell spoke about the crucial difference between financial market volatility and financial system instability. They are not one and the same.
The Fed’s job is to try to bring about policies — and often create new tools — to ease instability in the financial system. There are times that market volatility can lead to financial system instability. However, if market volatility occurs in a vacuum, it is not the Fed’s job to contain it — unless it actually threatens the stability of the financial system.
This year’s increased volatility and correction in stocks is indicative of a less friendly monetary policy. For all the benefits having accrued to the economy and investors’ portfolios of asset appreciation, the Fed is keenly aware that it is time to begin reining in some of the excess liquidity. Absent the renewal of the Fed put, not fighting the Fed remains the market’s modus operandi.