It’s the markets that make the news, not the other way around, an insight that’s been humble enough for one who has made a living reporting and analyzing the impact of news on the financial markets.
Consider the position of policy makers. With some justification, they believe that their decisions on interest rates or tax matters determine the fate of stocks, bonds and currencies. Yet they now view these markets as policy guides.
This can create a strange feedback loop. Bearish bond and equity markets can be viewed as positive developments, effectively performing the unpleasant task of policy tightening typically left to monetary authorities. Conversely, rebounds in debt and equity markets translate into easier conditions, requiring tougher actions by the central bank. Investors can therefore view bear market rallies as harbingers of further tightening to come.
The Federal Reserve has two main policy tools: setting short-term interest rates and buying and selling securities. These work through money and government securities markets and affect broader rates and securities prices only indirectly.
To gauge the impact of their actions, central bank officials monitor a wide range of financial areas, including the corporate credit, mortgage, currency and equity markets. This is where real money is collected and invested, and where monetary policy affects the economy as a whole.
Financial conditions have tightened far more than they should have, based solely on what the Fed has done. Instead, they were swayed primarily by what its officials said. Their actions consisted of just two increases in its federal funds target, from near zero to just 0.75%-1%, a low absolute rate and a record real rate, after factoring in price inflation at consumption above 8%.
As for the rhetoric, Fed leaders spoke of the need to quickly normalize their policy. It is all but certain that this will mean half-point increases in the federal funds rate at the June 14-15 and July 26-27 meetings of the Federal Open Market Committee, according to the minutes. released last week from the policy development group meeting. this month and comments from a range of central bank officials. Additional quarter-point hikes are expected at the final FOMC conferences this year, in September, November and December.
Anticipating these actions, plus the withdrawal of liquidity, starting with the reduction in holdings of Fed securities from June, measures such as the Chicago Fed’s National Financial Conditions Index have tightened significantly. This was due to the sharp rise in mid- to long-term bond yields, the concomitant rise in mortgage interest rates, the gains in the dollar and, of course, the fall in equities which briefly brought the
S&P 500 Index
in 20% bearish territory.
As painful as these moves may be for investors, they are part of the Fed’s job of reining in the economy and presumably slowing inflation. “It’s been good to see the financial markets react ahead of time, based on how we talk about the economy, and the consequence…is that overall financial conditions have tightened significantly,” the recently observed. Fed Chairman Jerome Powell, adding with obvious satisfaction: “This is what we need.”
To be sure, tighter terms are a necessary step away from the previous ultra-stimulative zero interest rate policy and Fed liquidity at a record $1.4 trillion annual rate. But can they bring inflation down after a four-decade peak?
Given the decline in interest rates and the rally in equity prices over the past week, the answer appears to be yes. Indeed, since early May, fed funds futures have discounted about two quarter-point hikes less by the first half of 2023, when the tightening is expected to peak. An upper range of 2.75% to 3% is now expected by February, according to the CME site FedWatch.
This was reflected in the sharp declines in Treasury yields since early May. The yield on the two-year note, the maturity most tied to anticipated Fed moves, slipped to 2.47% on Friday after an intraday peak of 2.80%. Meanwhile, the benchmark 10-year note fell from 3.20%, just below its peak in November 2018 during the last Fed tightening cycle, to 2.72%.
Yet after fears of growth from some retailers and
(ticker: SNAP), the stock market rebounded last week. The decline in Treasury yields also spilled over into the municipal and corporate bond markets, both investment grade and high yield. At the same time, measures of volatility, such as the
Cboe Volatility Index,
or VIX, for the S&P 500 and analogous measures for the bond market, also fell. All of this comes on top of an easing in financial conditions, after the previous market tightening.
Still, there are reasons to be cautious, says Edmund Bellord, asset allocation strategist at fund manager Harding Loevner. The Fed will likely have to lower asset prices to contain inflation, which he says is an inevitable corollary of its actions to boost spending by raising asset prices since the 2007-09 financial crisis.
So far, the impact on equities has mainly been felt in the higher discount rate applied to future earnings, Bellord adds in a telephone interview. The next phase will be a drop in cash flow, which he says could produce a “whiplash effect” in the markets.
In that vein, many observers note that the stock market’s price-earnings multiple has fallen significantly, to around 16.5 times expected earnings, from more than 21 times at its peak at the start of the year. But as Jeff deGraaf, head of Renaissance Macro Research, observes, analyst earnings estimates have been known to lag stock price movements. S&P 500 earnings revisions hit all-time low six weeks after stocks, he wrote in a client note. And true to form, earnings revisions have yet to be lowered significantly, despite the correction in the S&P 500.
Bellord admits his message – stock prices have yet to fall – has “the charm of an open grave”. But, he insists, the “twin bubbles” in real estate and stocks must be “popped” to create the demand destruction needed to bring inflation under control.
Asset deflation is likely to dampen spending by those who own stocks and property. The pain of losses is felt more intensely than the pleasure of gains, as psychologists Amos Tversky and Daniel Kahneman, winner of the 2002 Nobel Prize in Economics, said more than four decades ago. But after years of increased spending due to asset inflation, any complaint from those wealthy enough to own those assets is tantamount to a “groan,” Bellord says, using Britishism.
While the Fed’s attack on inflation is indeed aimed at financial markets in general, and stock prices in particular, recoveries in equity and credit markets may require additional central bank action. Investors would do well to remember that Powell & Co. tightened mostly in words, not deeds. Further significant rate hikes and a shrinking of the Fed’s balance sheet are ahead, with inevitable deleterious effects. Markets will likely announce more bad news at that time.
Write to Randall W. Forsyth at [email protected]