This Rally Could Force the Fed to Raise Rates Higher
The markets make the news, not the other way around, an insight that has been quite humbling to one who has made a living by reporting and analyzing the impact of news on financial markets.
Consider the position of policy makers. With some justification, they think their decisions about interest rates or fiscal matters determine the fates of stocks, bonds, and currencies. Yet they now look to those markets as policy guides.
That can set up a strange feedback loop. Bond and stock bear markets may be seen as positive developments, effectively performing the unpleasant task of tightening policies typically left to the monetary authorities. Conversely, rebounds in debt and equity markets result in easier conditions, requiring harsher central bank actions. So investors may view bear-market rallies as harbingers of more tightening down the road.
The Federal Reserve has two main policy tools: setting short-term interest rates, and purchasing and selling securities. These work through the money and government securities markets, and affect broader rates and securities prices only indirectly.
To gauge their actions’ impact, central bank officials monitor a broad range of financial arenas, including the corporate credit, mortgage, currency, and equity markets. That’s where real money is raised and invested, and where monetary policy affects the overall economy.
Financial conditions have tightened far more than they should have, based solely on what the Fed has done. Instead, they have been influenced mainly by what its officials have said. Their actions have consisted of just two increases in its federal-funds target, from near zero to only 0.75%-1%, a low absolute rate and a record-low real rate, after taking into account consumer price inflation over 8%.
As for rhetoric, Fed leaders have spoken of the need to normalize their policy stance expeditiously. That’s all but certain to mean half-point increases in the fed-funds rate at the June 14-15 and July 26-27 meetings of the Federal Open Market Committee, according to the minutes released this past week of the policy-setting panel’s meeting this month and comments from an array of the central bank’s officials. Additional quarter-point hikes are anticipated at the remaining FOMC confabs this year, in September, November, and December.
Anticipating those actions—plus the withdrawal of liquidity, beginning with the reduction of the Fed’s securities holdings starting in June—measures such as the Chicago Fed’s National Financial Conditions Index have tightened meaningfully. That’s resulted from the sharp rise in intermediate-to-long-term bond yields, the concomitant jump in mortgage interest rates, the dollar’s gains, and, of course, the stock slide that briefly brought the
S&P 500 index
into 20%-decline bear market territory.
Painful as those moves might be for investors, they are doing some of the Fed’s work to restrain the economy and presumably slow inflation. “It’s been good to see financial markets reacting in advance, based on the way we’re speaking about the economy, and the consequence…is that overall financial conditions have tightened significantly,” Fed Chairman Jerome Powell recently observed, adding with evident satisfaction: “That’s what we need.”
Surely, tighter conditions are a necessary step away from the previous ultra-stimulative policy of zero interest rates and the Fed force-feeding liquidity at a peak annual pace of $1.4 trillion. But can they bring inflation down from a four-decade peak?
Based on the decline in interest rates and the recovery in equity prices this past week, the answer would appear to be yes. Indeed, since early May, fed-funds futures have discounted about two fewer quarter-point hikes by the first half of 2023, when the tightening is expected to peak. A top range of 2.75%-3% now is forecast by February, according to the CME FedWatch site.
This has been reflected in Treasury yields’ sharp declines since early May. The yield on the two-year note, the maturity most tied to anticipated Fed moves, slipped to 2.47% Friday from an intraday peak of 2.80%. Meanwhile, the benchmark 10-year note has pulled back from 3.20%, just short of its November 2018 apex during the Fed’s last tightening cycle, to 2.72%.
Yet after the growth scares from some retailers and
(ticker: SNAP), the equity market rebounded this past week. The retreat in Treasury yields has 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 have been tamped down. It all adds up to an easing of financial conditions, after the markets’ previous tightening.
Still, there are reasons to be cautious, says Edmund Bellord, asset allocation strategist at fund manager Harding Loevner. The Fed is likely to have to bring down asset prices to restrain inflation, which he calls an inevitable corollary to its actions to stimulate spending by boosting asset prices since the 2007-09 financial crisis.
Thus far, the impact on stocks has been mainly felt on the higher discount rate being applied to future earnings, Bellord adds in a telephone interview. The next phase will be lower cash flows, which he says could produce a “bullwhip 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 forecast earnings from over 21 times at its peak at the turn of the year. But as Jeff deGraaf, head of Renaissance Macro Research, observes, analysts’ earnings estimates are notorious for lagging behind movements in stock prices. S&P 500 earnings revisions historically bottom out six weeks after stocks do, he writes in a client note. And true to form, earnings revisions have yet to be brought down meaningfully, despite the correction in the S&P 500.
Bellord concedes that his message—stock prices must fall further—has “the charm of an open grave.” But, he insists, the “twin bubbles” in real estate and equities must be “detonated” to create the demand destruction needed to tame inflation.
Asset deflation is apt to curb spending by those who hold stocks and property. The pain of losses is felt more acutely than the pleasure from gains, as psychologists Amos Tversky and Daniel Kahneman, winner of the 2002 Nobel Prize in economics, articulated more than four decades ago. But after years of boosts to their spending from asset inflation, any complaints from those wealthy enough to own those assets amount to “whinging,” Bellord says, using the Briticism.
If the Fed’s attack on inflation is indeed targeting financial markets in general, and stock prices in particular, rallies in the equity and credit markets could require further action by the central bank. Investors would do well to recall that Powell & Co. have mainly tightened in word, not deed. Further significant rate hikes and Fed balance-sheet reduction lie ahead, with inevitable deleterious impacts. The markets will likely make more bad news then.
Write to Randall W. Forsyth at email@example.com