This rally could force the Fed to raise rates higher

The markets make the news, not the other way around, an idea that has been quite humbling for someone who has made a living reporting and analyzing the impact of news on financial markets.

Consider the position of policymakers. With some justification, they think their decisions about interest rates or tax matters determine the fate of stocks, bonds, and currencies. However, they now look to those markets as policy guides.

That can set up a weird feedback loop. Bear markets in bonds and equities can be seen as positive developments, effectively performing the unpleasant task of tightening policy that is normally left to the monetary authorities. By contrast, rallies in debt and equity markets result in more favorable conditions, requiring tougher actions from the central bank. Investors may therefore see bear market rallies as harbingers of more tightening to come.

The Federal Reserve has two main policy tools: setting short-term interest rates and buying and selling securities. These work through the government securities and money markets, and affect broader rates and security prices only indirectly.

To gauge the impact of their actions, central bank officials monitor a wide range of financial arenas, including corporate credit, mortgage, foreign exchange and equity markets. That is where real money is raised and invested, and where monetary policy affects the economy as a whole.

Financial conditions have tightened much more than they should, based solely on what the Fed has done. Instead, they have been influenced primarily by what its officials have said. His actions have consisted of only two increases in his federal funds target, from almost zero to just 0.75%-1%, a low absolute rate and a record low real rate, after accounting for consumer price inflation above of 8%.

As for rhetoric, Fed leaders have spoken of the need to quickly normalize their policy stance. That almost certainly means 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 minutes released last week from the meeting. of the policy setting panel. this month and comments from a number of central bank officials. Additional quarter point increases are anticipated at the remaining FOMC meetings this year, in September, November and December.

In anticipation of those actions, plus the withdrawal of liquidity, beginning with the reduction of the Fed’s securities holdings beginning in June, measures such as the Chicago Fed’s National Index of Financial Conditions have tightened significantly. That’s the result of the sharp rise in medium- and long-term bond yields, the concomitant jump in mortgage interest rates, the dollar’s gains, and, of course, the stock slump that was briefly brought on by the


S&P 500 Index

in bear market territory with a 20% drop.

As painful as those moves may be for investors, they are doing part of the Fed’s job of tightening the economy and, presumably, curbing inflation. “It’s been good to see the financial markets react early, based on the way we talk about the economy, and the consequence … is that overall financial conditions have tightened significantly,” Fed Chairman Jerome recently observed. Powell, adding with obvious satisfaction: “That’s what we need.”

Surely, the tighter conditions are a necessary step away from the previous ultra-stimulant policy of zero interest rates and the Federal Reserve’s force-feeding liquidity at a maximum annual rate of $1.4 trillion. But can they bring inflation down from a four-decade high?

Based on the drop in interest rates and the recovery in stock prices last week, the answer would appear to be yes. In fact, since early May, fed funds futures have priced in about two less than a quarter-point hike for the first half of 2023, when the tightening is expected to peak. A range top of 2.75%-3% is forecast now for February, according to the CME FedWatch site.

This has been reflected in the sharp declines in Treasury yields since early May. The yield on the two-year note, the maturity most closely tied to anticipated Fed moves, fell to 2.47% on Friday from an intraday high of 2.80%. Meanwhile, the benchmark 10-year note has retreated from 3.20%, just below its November 2018 peak during the latest Fed tightening cycle, to 2.72%.

However, after growth fears from some retailers and

Nap

(ticker: SNAP), the stock market rallied last week. The pullback in Treasury yields has also spilled over into corporate and municipal bond markets, both investment-grade and high-yield. At the same time, measures of volatility, such as the


cboe Volatility Index,

o VIX, for the S&P 500 and analogous measures for the bond market, have also been repressed. It all adds up to an easing of financial conditions, after the previous tightening of the markets.

Still, there are reasons to be cautious, says Edmund Bellord, asset allocation strategist at fund manager Harding Loevner. The Fed will likely have to cut asset prices to contain inflation, which he calls an inevitable corollary of its actions to stimulate spending by raising asset prices since the 2007-09 financial crisis.

So far, the impact on the stock has been felt primarily in the higher discount rate applied to future earnings, Bellord adds in a phone interview. The next phase will be the reduction of cash flows, which, according to him, could produce a “bullwhip effect” in the markets.

In that regard, 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 earlier in the year. But as Jeff deGraaf, head of Renaissance Macro Research, notes, analysts’ earnings estimates are notorious for lagging movements in stock prices. Historically, S&P 500 earnings revisions bottom six weeks after stocks, he writes in a client note. And true to form, earnings revisions have yet to slow significantly, despite the correction in the S&P 500.

Bellord admits his message—share prices need to fall further—has “the allure 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 control inflation.

Asset deflation tends to curb spending by those who own stocks and property. The pain of loss is felt more intensely than the pleasure of gain, as psychologists Amos Tversky and Daniel Kahneman, winner of the 2002 Nobel Prize in Economics, put it more than four decades ago. But after years of rising spending by asset inflation, any complaints from those wealthy enough to own those assets amount to “groans,” says Bellord, using Britishism.

If the Fed’s attack on inflation is indeed targeting financial markets in general, and equity prices in particular, rallies in equity and credit markets could require additional action by the central bank. Investors would do well to remember that Powell & Co. has toughened up mainly in words, not deeds. More significant rate hikes and a shrinking of the Fed’s balance sheet are expected, with inevitable deleterious impacts. The markets are likely to deliver more bad news at that point.

write to Randall W. Forsyth at randall.forsyth@barrons.com

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