The writer is chief investment strategist at Charles Schwab
Don’t fight the Fed. The saying was popularized by the late Marty Zweig, this author’s first Wall Street boss and mentor in the 1980s and 1990s. Zweig also coined the phrase, “Don’t fight the gang.”
The band – the all-day stock trading record – is decidedly not fighting the US Federal Reserve, with the prospect of monetary policy normalization clearly behind a very difficult start to the year for US equities. It’s usually a pothole-riddled path created when central banks begin to normalize policy – even more so during this anything but normal time. pandemic cycle (there is a new word for you).
Admitting that inflation is not quite a transitory phenomenon, the Fed is now on a mission. The launch point of the Covid-19 tightening cycle is unusual, in part due to what appears to be a much later phase in the cycle of the economy than the calendar suggests. The 2020 post-recession expansion is only 21 months new, but the inflation, labor market and asset valuation backdrop is decidedly later.
Much of the recent analysis of past tightening cycles has been limited to the previous three rounds of Fed rate hikes, but those date back only to 1999 – an era characterized by secular disinflation and the positive correlation that goes with it. results between bond yields and stock prices. It’s different this time.
The inflation cat is out of the bag; and it can be said that the Fed deliberately opened the bag when in August 2020 it implemented a more flexible monetary policy strategy. In short, the Fed is actively pursuing higher inflation. The goal is to let inflation soar to compensate for the long period of disinflation.
Another key difference between the current path to policy normalization and past episodes is the Fed’s $9 billion balance sheet. Markets may be acutely aware of the perceived implications of its bond-buying quantitative easing program on yields and asset prices; but they have much less experience with impending quantitative tightening.
The plumbing system that connects QE (or QT) to asset prices is indirect and complex. But the psychological system that connects them tends to be more direct. Signals from the Fed regarding balance sheet plans were important market drivers – underscoring the power of the Fed’s words, that is, jawbone.
Fed officials are now explicitly expressing their desire to tighten financial conditions in an effort to move away from hyper-stimulative policies, compress aggregate demand and lower inflation. No, the impending rate hikes do nothing to solve the semiconductor backlog problem, nor do they reduce the number of container ships off the ports of Long Beach. However, coupled with the jawbone of the Fed, they can arguably alter the trajectory of inflation expectations and/or aggregate demand via consumer behavior.
The hope is that the economy and financial markets can adjust to the normalization of monetary policy in an orderly fashion. But this is where things could get complicated. The notion of a “Fed put” has been in and out of play since the Alan Greenspan era; many market participants believing that the central bank will intervene if the markets start to revolt. Don’t count on it at this time.
For now, the financial markets are volatile, but functioning well. Volatility and weakness occur alongside the revaluation of risky assets, without being driven by a severe deterioration in liquidity conditions or the functionality of the financial system. In fact, the equity market is a component of most indices measuring financial conditions. As such, the tightening of financial conditions induced by stock market volatility could arguably be a feature, not a bug, with respect to future Fed decisions.
In 2018, Fed Chairman Jay Powell spoke about the crucial difference between financial market volatility and financial system instability. They are not identical.
The job of the Fed is to try to put in place policies – and often to create new tools – to mitigate the instability of the financial system. There are times when market volatility can lead to financial system instability. However, if market volatility is occurring in a vacuum, it is not the Fed’s job to contain it, unless it truly threatens the stability of the financial system.
The increased volatility and correction in equities this year are indicative of less supportive monetary policy. For all the benefits of asset appreciation to the economy and investors’ portfolios, the Fed is acutely aware that it’s time to start getting some of the excess liquidity under control. In the absence of the renewal of the Fed’s put, not fighting the Fed remains the modus operandi of the market.