Recently, there has been a major change in the way the Fed has approached their role in monetary policy and how their actions have impacted the global investment markets. This change could have a large impact on the short term direction of the investment markets.
In fact, the Fed has already had a significant impact on the markets. The major averages lost nearly 20% from their early October highs to the low in December. The Nasdaq actually tumbled into an official bear market. Then, stepping into the fray came the current Chairman of the Federal Reserve, Jerome Powell to declare he was “prepared to adjust policy quickly and flexibly”… and that he was “listening carefully” to markets.
He further pledged to announce a halt to quantitative tightening “if needed.”
“We wouldn’t hesitate to change it,” he reassured Wall Street.
Investment markets now know Powell is behind them if the bears draw too close…
As they knew Yellen was behind them… and Bernanke before her… and Greenspan before him.
The Dow Jones has recaptured almost 4,000 points since its Dec. 26 bottom.
The S&P and Nasdaq have put on a similar show.
So, have the underlying economic conditions brightened so much to justify the rebound?
Understanding the History of the Fed Dance
Well…not exactly. In fact it’s just the opposite. Economic fundamentals and earnings per share (EPS) growth have weakened since the start of the year.
Doesn’t a Federal Reserve about-face mean it spots trouble ahead? Why else would it back off?
We look at history to learn the patterns.
At the birth of our Nation, 1775 – 1791, in order to finance the American Revolution, the Continental Congress printed the new nation’s first paper money.
We created a central bank, allowed it to expire, created a new central bank, again it failed. From 1775 when we started printing the nation’s first paper money to the early 1900’s the market rose and fell, saw growth and recessions.
Challenges to the U.S. and global economies (WW1 and WW2, the Great Depression, the Dotcom Bubble, 9/11 and the 2008 Financial Crisis), brought many changes to the way the Federal Reserve operated and the impact they had on economic growth and currency operations.
The central banking system we have today didn’t come into being overnight. There was a lot of trial and error.
Up until the 2008 event however, the Fed operated under basically two mandates: keeping the level of inflation within certain boundaries, and promoting as much as possible, full employment of U.S. citizens. Beginning with the appointment of Alan Greenspan in 1987, many economic and market pundits however believe the Fed has taken on a third, “unofficial” mandate: to make sure asset prices rise and are sustained at an elevated level to keep the investment markets humming along.
Introduction of the Federal Reserve “Put”
It started with the Greenspan “Put” (The term “put” refers to a put option, a contractual obligation giving its holder the right to sell an asset at a particular price to a counterparty – which is often used by traders as a method to protect from price declines) which morphed into the Bernanke “Put” and continued with the Yellen “Put”. And what did we get? A series of bubbles.
- As Stan Druckenmiller says, the really big Fed mistake was when Greenspan kept rates too low for too long in 2003–2004, setting up the housing bubble and Great Recession.
- Then Bernanke’s reluctance to raise rates above zero in 2012–2013, when the economy was clearly recovering, refueled the asset price bubble.
- Yellen continued that course. Her reluctance to raise rates until Trump won the election, the economy was booming, and unemployment clearly falling has led to the current market peak.
- The current chairman – Jerome Powell seemed to be cut from a different cloth – or so it seemed for a while.
Markets Under Powell
Powell worked on Wall Street, is very wealthy and was an investment banker, ran his own hedge funds, and served in numerous posts for the Treasury before he came to the Fed, so he is clearly an “insider.” He is also wicked smart. At the start of his tenure he seemed to be breaking from the pattern of his predecessors and made comments clearly stating he thought the Fed should not be concerned about any movements of the equity markets. As he saw it, 10 years plus on from the financial crisis, rates were too low and his job was to continue moving the level of interest rates upward toward “normalization”, while reducing the size of the bloated balance sheet. In fact, in mid-December, 2018, he made a speech clearly reiterating these objectives.
The equity markets promptly threw a temper tantrum and we saw them hit their recent low just a few days afterward. Within 2 weeks, Powell made another speech in which he took a 180 degree turn – saying the Fed may have already brought rates up to their “normal” levels and promising “patience” to manage the reduction in the balance sheet slowly in relation to the economic environment.
“Patience” isn’t just a word. It’s a signal to markets that the Fed will probably not be raising rates or reducing its balance sheet anytime soon, and that it will give them notice when it is ready to do so.
The most important signal here is what was once supposed to be an emergency measure – bloating the balance sheet with quantitative easing (QE) – could become just another regular policy tool if normal interest rate policy isn’t enough to stimulate a non-responsive economy. We’ll have to wait and see if this idea gains traction within the Fed. Either way, reducing the balance sheet to “normal” levels is no longer a priority for the Fed.
In essence – he caved to pressure – most likely from the market, the White House, the regional Federal Reserve Banks, maybe even his own portfolio value – who knows.
But bottom line, he joined the ranks of the last three fed chairs to provide a “Put” to the markets – when they throw a tantrum – he will add liquidity to the financial system in an effort to keep them moving ever higher, and stretching the valuation even further.
In my opinion, this is a real shame. We had a chance to have a Fed chairman who understood the real mandate of his job, and not a Wall Street lacky.
The Federal Reserve should be just as concerned about Main Street as it is about Wall Street. The serial bubbles of the last 30 years all had serious negative consequences. Yes, the ride was often fun, and some folks made good money in both the up and down cycles. But Main Street would be better served with a steady-as-she-goes Fed policy.
As you here us routinely say, if you don’t have a financial plan – get one done. Having a sound plan in place will help you stick to your discipline when volatility picks up and things get a little uncertain.
Randy has more than 15 years of experience managing financial assets for individuals, retirement plans and businesses. Randy joined YHB | Wealth Advisors in January of 2018 and serves as the Director of Wealth Management. Prior to entering the professional wealth management field, he enjoyed building entrepreneurial business ventures from start-up to eventual sale and providing accounting services for public and private firms.