FOVL - The Federal Reserve: Still Throttling Market Sentiment

Summary

• The markets remain stuck in a Bearish phase.
• The United States Federal Reserve and the pivot to monetary tightening is a primary reason for the pessimism and despair.
• A series of economic and geopolitical events have helped shape this reality.
• Until the Fed eases and macroeconomic and geopolitical factors improve, market sentiment is unlikely to turn bullish.
• Some reduction of the monetary strictness - even without a clear pivot to easing - is the first step towards improving sentiment.

Introduction

The markets are in turmoil, volatile, and destroying wealth in every direction. Investors are frightened, wary, and jumpy. Many - including institutional investors - have reduced equity positions and increased cash and fixed-income allotments. Others, burned by investments in high-growth stocks, meme names or cryptocurrency, have likely fled the markets for good.

The optimistic or even euphoric approach of a year ago has yielded to a deep collective pessimism. It is against this background that the Federal Reserve Bank decides the extent of the looming interest rate hike and Chairman Jerome Powell provides near-term policy guidance.

The 'Fed' has this division of functions and corresponding responsibilities . After a long period of loose policy characterized by quantitative easing and a near-zero interest rate policy, the Fed pivoted in 2021 with an emphasis on tightening to combat rapidly growing inflation.

These decidedly tough policies had an immediate impact on markets, driving optimism away and replacing it with near-universal pessimism and bearishness. Throughout 2021, investors and traders were happily oblivious to growing US and international deficits and basically addicted to liberal central bank monetary policies that spread mass liquidity through quantitative easing and extremely low-interest rates. The long Bull run seemed a permanent thing.

All of this has come crashing down.

Investors have all watched as the effects of the Covid pandemic played out through work furloughs and office shut-downs, trade wars, and increased government spending - often in the form of mass periodic payments to citizens living in distress. While this official largesse was doubtless helpful to many facing reduced incomes and savings, it also fed a silent wave of inflation that directly stimulated central bank tightening.

Meanwhile, a massive war in Ukraine caused by a wholesale Russian invasion in early 2022 acted alongside inflation as a co-destabilizer for markets. The economic costs of the war included the obvious disruption to energy and food markets produced by Ukrainian and NATO resistance to Vladimir Putin's effort to destroy Ukraine as a sovereign state. Inflation and the resultant monetary about-face would have been enough, but the Ukraine conflict provided geopolitical kindling to a fire that was starting all on its own.

Once inflation began to 'outperform' in official metrics released in early 2022, the Federal Reserve pivoted from monetary permissiveness to monetary strictness. Under Jay Powell's leadership, it announced the end of the large balance sheet and a shift to eventual quantitative tightening.

With reference to the most visible piece of its mandate - interest-rate policy - the tough turn showed in repetitive, sharp interest rate raises. And while the current rates are still far below some past numbers, the percent of their increase is stunning. Going from .25% to a number above 4% is an enormous change - including psychologically. The effect is much greater than a hypothetical increase from 4.25% to 8%.

The markets have reacted most negatively to all of this. Bubbles have popped and meme stocks, NFTs and cryptocurrencies have suffered greatly. Along with them, a raft of investors - many hopeful newbies - have seen expectations of easy wealth turn blood-red. Pain, not pleasure, has characterized investors' experiences for a full year.

Fed Logic And Fed Policy

When the Federal Reserve announces a rate hike, the markets react. Repetitive rate hikes have occurred since monetary tightening became the policy:

"The six rate hikes the Fed has already imposed this year have raised its key short-term rate to a range of 3.75% to 4%, its highest level in 15 years. Cumulatively, the hikes have led to much costlier borrowing rates for consumers as well as companies, ranging from mortgages to auto and business loans. Worries have grown that the Fed is raising rates so much in its drive to curb inflation that it will trigger a recession next year."

"Yet with price increases still uncomfortably high - inflation was 7.1% in November compared with a year earlier - Powell and other Fed officials have underscored that they expect to keep rates at their peak for an extended period."

The combination of a reduced rate hike - down from 75 basis points to 50 - along with a further reduction or pause in a few months should encourage the markets. However, 'underscoring' the intent to maintain the eventual target level (4.75-5%) is likely to have a dampening effect on renewed investor optimism. Encouragement seized from a reduction in the rate of the hike compared to previous raises is almost certain to be at least partly nullified by Jay Powell's words.

An important point made by Fed Governor Lisa Cook casts light on the caution in Jay Powell's post-hike announcement:

"'What policy rate is sufficiently restrictive we will only learn over time by watching how the economy evolves,' said Lisa Cook, one of seven members of the Fed's Board of Governors. 'Given the tightening already in the pipeline, I am mindful that monetary policy works with long lags.'"

We should not expect the Fed to actually pivot in the near future. Instead, it will wait to see if the monetary restrictions are fundamentally attacking inflation.

Given that the Federal Reserve missed the inflation story badly, I think this only exacerbates the members' cautious approach. Nobody likes to be caught out making mistakes, and certainly not those in the public eye. That is so even if in retrospect the current monetary rigor is seen as overkill.

Monetary Tightening And Market Reaction

How do monetary tightening and interest rate hikes in particular affect markets and investor behavior? What functional effects do they have on public businesses and their results, and on those investing in them?

Here is a clear explanation that includes investor interaction with particular stocks :

"When Fed rate hikes make borrowing money more expensive, the cost of doing business rises for public (and private) companies. Over time, higher costs and less business could mean lower revenues and earnings for public firms, potentially impacting their growth rate and their stock values."

"If the cost of borrowing money from a bank increases, the opportunity to expand investment in capital goods by a corporation stalls," says Dan Chan, a Silicon Valley investor and a former pre-IPO employee of PayPal. "The interest rate may be so high that many companies will not be able to afford to grow."

"More immediate is the impact Fed rate increases have on market psychology…when the FOMC announces a rate hike, traders might quickly sell off stocks and move into more defensive investments, without waiting for the long, complicated process of higher interest rates to work their way through the entire economy."

Has it worked that way during the 2022 selloff? Have investors sold off higher-risk, higher-growth names in favor of defensive ones or swapped large stock holdings for cash or fixed instruments?

Enough have done one or both that share prices for many successful companies have in fact been beaten down severely.

When And How Will Markets Recover?

That is the driving question for analysts, investors, traders, business leaders and observers of different stripes and flavors.

Corporate budget and planning projections have been hit hard, and in the past few months, systematic layoffs and hiring freezes have roiled the waters further. Analysts have fairly projected reductions in upcoming quarterly earnings, both at the individual company level and in a general way. And investors? Many have in fact followed the script presented by Dan Chan and moved to much more conservative postures.

Traders may have some superb opportunities - assuming they are learned and clever. Investors , though, face the constant dilemmas of a Bearish environment - including decisions on whether to cut loose higher-risk names and whether to trust their savings again to an ostensible wealth-building mechanism that threatens to consume its theoretical beneficiaries.

A number of things will have to happen for the Bull to reassert himself. These include:

• The market's sense that the Federal Reserve in particular and central banks in general are readying a pivot to an easier monetary policy;
• Clear signs that the rate of inflation will continue to drop;
• Corporate earnings that come in better than expected;
• An improvement in the geopolitical aspect of the macro picture.

There are other factors too, but I see these as the keys to a shift to positive investor sentiment. I plan to explore this further in a companion piece to this article.

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