Why the Fed May Have Rattled Markets

How quickly things change. In early June, as parts of the U.S. started to reopen and some economic data began surprising to the upside, U.S. markets were on the rise. The S&P 500, the broad benchmark of the U.S. market, peaked on June 8^th at 3232, a little more than 150 points shy of its all-time high, and up nearly 45% in less than three months. The stock market’s capitalization seemed more disconnected from corporate profits than ever before, and I was concerned about valuations in some sectors.

Then came the June 10th release of the meeting statement from the Federal Open Market Committee, the policy-setting arm of the Federal Reserve. Fed Chair Jerome Powell shared a downbeat set of economic projections and indicated that the key short-term interest rate it controls, the fed funds rate, was likely to remain at zero through the end of 2022. The next day, the S&P 500 fell 6%. There may be several reasons why investors seemed to recoil in shock after the Fed meeting:

• The Fed’s economic outlook was much worse than expected. An unexpected drop in the overall U.S. unemployment rate and reopening state economies had put investors in an optimistic frame of mind. Yet the Fed’s projections suggested that U.S. GDP will fall 6.5% this year and remain 1.8% below its pre-coronavirus level by the end of next year. That’s far from the V-shaped recovery that many thought was taking shape. It also raises the question of why the Fed isn’t more confident that the massive amounts of stimulus already in place can revive the economy.

• Aggressive Fed bond buying can make it harder to value securities. Since the fed funds rate is already near zero, the Fed’s main tool to keep rates low would be more “quantitative easing,” or buying and holding bonds. Injecting such massive amounts of additional liquidity in the credit market can distort the valuations of many types of securities—including stocks, which are often valued based on their expected return above the yield of a low-risk Treasury. Persistently low rates can distort the equity risk premium, a key valuation metric that has served investors well for the past decade.

• What if the Fed is wrong and inflation takes hold? The impact of so much fiscal and monetary stimulus should cause inflation to rise. Normally, that would push bond prices lower and interest rates higher, acting as a brake on the economy by raising borrowing costs, which in turn can cause stock market declines. Is the Fed suggesting that it may seek to suppress long-term as well as short-term rates? That level of monetary intervention could cause the U.S. dollar to weaken against other major currencies, such as the yen and the euro, while raising enormously complex economic policy questions that worry market strategists like myself.

Morgan Stanley & Co. Chief U.S. Economist Ellen Zentner wrote after the meeting that she believes the Fed’s guidance on interest rates may have been intended to reassure investors that it isn’t about to start reducing its bond-buying program. I think the Fed may also have been trying to tame investors’ recent bullish exuberance.

Regardless, the Fed seems to have stoked investor uncertainty and rekindled volatility in markets. My advice for investors is to keep an eye on inflation expectations and build exposure to commodities, including gold, in case the Fed just made a big policy mistake.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from June 15, 2020, “Has the Fed Crossed the Rubicon?” Ask your Financial Advisor for a copy or find an advisor. Listen to the audiocast based on this report.