Thinking Beyond Fed Signals in the Current Cycle

Stock and bond markets adjusted sharply last week, following the Federal Reserve’s projection of two interest-rate hikes in 2023. Volatility persisted through the end of the week after St. Louis Fed President James Bullard said he sees an initial rate increase happening as early as 2022.

The surprise display of Fed hawkishness may topple the prevailing “reflation trade” theme, which focuses on investments that traditionally benefit from economic expansion and rising consumer prices. Yields on longer-term bonds fell, while short-term yields rose and the dollar strengthened against other major currencies. In the U.S. stock market, growth stocks gained, while value stocks declined.

The degree to which markets responded to the Fed’s apparent pivot indicates that investors still have a lot of faith in the central bank’s narrative. Yet some of the recent volatility may have been technical noise, coupled with investors’ eagerness to rely on Fed positioning to dictate their own.

Which brings us to a perennial debate: Do economic data and markets dictate Fed policy, or does policy drive the data and markets? Clearly, the latter seemed dominant over the 11 years following the financial crisis of 2008, when a benign inflation and interest-rate backdrop allowed the Fed to navigate with little consideration for growth, employment or inflation data. For the most part, volatility stayed tame, and U.S. stocks enjoyed one of their best historic bull runs.

No wonder then that investors became hypersensitive to every word of “Fed speak” over this period. The major drawdowns of the past cycle help to accentuate this reliance: Both the “Taper Tantrum” of 2013 and the plunge into bear-market territory on Christmas Eve of 2018, for instance, have been ascribed to apparent signaling by the central bank.

Not only are we in a new economic cycle, but we’re likely entering the middle of what we believe will be a shorter and hotter one. In this environment, investors may want to take more than just Fed positioning into account as they navigate a more complex market phase. Today’s Fed policy tools, while largely the same as those it employed during the financial crisis, are playing out amid market dynamics that are vastly different from those of the prior cycle. Consider these factors: 

• Objective and scale of intervention: Back in the global financial crisis era, the Fed’s policy objective was to resolve a credit crisis. Its monetary tools could directly ameliorate and control liquidity, which was the source of distress. Today’s Fed has been responding to the economic impact from a public health crisis with unprecedented speed and scope—alongside similarly unparalleled fiscal spending, which will likely drive economic growth and fuel inflation.

• Plenty of cash vs. unpredictable disruptions: The nature of the post-pandemic economic recovery has been highly unpredictable. Households are sitting on piles of excess savings, and corporate cash coffers have also hit historic highs; but supply-chain bottlenecks have proven disruptive to many businesses, and inflation data have been alarmingly strong. At the same time, shifts in behaviors around work appear to be weighing on the labor market recovery.
  

• Different policy goalposts: Finally, and critically, all this is occurring as the Fed has embraced a completely new policy framework. The central bank has shifted away from the traditional belief that lower unemployment leads to higher levels of inflation and, instead, is pursuing goals of “average inflation targeting” and “maximum employment.” In this newly engineered framework, the Fed has been less than clear about the extent to which they will be driven by forecasts or by data.
  

This doesn’t mean investors should ignore central bank signals. Monetary policy and the timing of policy shifts still matter. But, in addition, investors should consider the direction and level of intermediate- and long-term interest rates, as they are key determinants of credit and stock valuations. Watch also for shifts in short- and long-term bond yields, for a steepening of the yield curve.

Further, we suggest that investors continue to position their portfolios for higher rates and inflation in the intermediate term. That means avoiding extreme style biases and focusing on trimming excessively priced securities in favor of quality value stocks and growth stocks at a reasonable price.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from June 21, 2021, “Fed Fake.” Ask your Financial Advisor for a copy or find an advisor. Listen to the audiocast based on this report.