As our members and regular readers would know, we are NOT a financial news site, and do not write endless articles on every thing that happens each day just to provide filler and the appearance of providing lots of content. Frankly, we find that actually counter-productive for medium to long term investors who don’t want to be constantly jumping at shadows. Its just too much information, which leads to cluttered minds on what to ACTUALLY DO about it all. This is why the Morning Report is just a short concise summary of both the overnight action and the ASX of the previous day. And in the weekly Portfolio Strategy Update, whilst we highlight the narratives of the day, we keep our members more focussed on the key fundamentals and the risk monitor, with an overlay of the trends. In other words, a consolidated view of the things that actually matter. Suffice to say, these do NOT change on a daily basis.
However, every now and then a piece of ‘financial news’ does indeed justify its own piece and some focussed attention, and this is one of them. Overnight, the US Federal Reserve announced a significant shift in its policy position, and if there is one thing we all know by now, its that Fed policy is one of the most important drivers of modern day global financial markets. So lets see what just happened.
In March 2020 as the COVID pandemic was unfolding and global financial markets were melting, the Fed introduced a number of emergency policies to help shield the worlds largest economy from the fallout of it all. The two main ones (which still exist today) were the near-zero interest rate policy (we’ll get to that shortly) and the bond buying program, otherwise known as QE, or Quantitative Easing.
QE consisted of buying $120 billion a month in bonds, to provide liquidity to markets and to supress longer term interest rates. In investment markets, this has proven to be very effective in raising asset prices. The stock market loves QE. However given that US employment has recovered enormously and inflation is hitting multi-decade highs, the Fed has been signalling for some months now that tapering could begin. Indeed at last month’s meeting, the Fed did just that and announced that tapering would begin by $15 billion in November, then $30 billion in December, and then will accelerate more in 2022.
Last night however, they took it a step further and announced that they will further accelerate this reduction in monthly bond purchases. The Fed will only buy $60 billion of bonds each month starting in January (which is half the initial level) and $30 billion less than what it will buy in December. All up, they plan on being done by around March 2022. That is not far away now.
The other central plank to Fed policy has been the near-zero interest rate policy. Overnight, the Fed announced no immediate change to the overnight rate of 0 – 0.25%. However the big change was that once QE ends around March, the next step is to start raising rates in 0.25% increments. The expectation is for as many as 3 rate hikes in 2022, another two in 2023, and another two in 2024.
We have been saying for some time now that the Fed has run out of excuses to keep monetary policy on emergency settings. In fact, when one steps back from it all, it looks quite ridiculous to still be on these settings with the business cycle at cycle highs, the equity markets hitting new all time highs on a regular basis this year, and the labour market in such a tight state. Is it any wonder that inflation has hit 3 decade highs.
And make no mistake, this inflation at levels not seen in most current careers is at the heart of it. The narrative of the Fed that inflation would prove fleeting and transitory (pinning it all on supply chain issues which we have disputed in previous articles) has proved false, and even they now acknowledge it, with Jerome Powell stating, “The pace of inflation is uncomfortably high. The risk of higher inflation becoming entrenched has increased”, also adding that “part of the reason behind our move today is to put ourselves in a position to be able to deal with that risk.”
Is any of this a surprise?
No, not really. The Fed have actually been telegraphing something like this for a while, and hence the market reaction was that the S&P500 actually went up by 1.63% overnight. The market does not like surprises and took this one in its stride. So far anyway.
Here is how it breaks down for investors:
Now whilst the media focusses on what is happening at the time (like rising yields or the Fed increasing rates), you need to understand this fundamental point. Changes in bond yields and the Fed overnight rate DO NOT affect the real economy or leading economic indicators (which the market reacts to) straight away. Rather, it takes quite some time for that to happen. That’s not actually our concern.
Our major concern is that the Fed is embarking on a tightening cycle just as the business cycle is forecast to peak and roll over. CLICK HERE (if you are a current paid member) to see our ISM business cycle model to see what I mean.
In other words, tightening into a slowdown. NOT GOOD.
This is why I have serious doubts that the Fed is going to get anywhere near all those projected rate rises. Some maybe, but not all. The lagged effect of previous tightening in the pipeline (of which inflation is one) is going to be hitting the real economy early in 2022 (again see the ISM model chart) and continuing throughout the year. This should show up in the high frequency growth and inflation data, which in turn the market will be reacting to. The Fed showed in late 2018 it is hostage to the financial markets. If the market pukes (which it will if growth and inflation trend lower), then the Fed is likely to put rate rises on the shelf and may just panic in the other direction.
Wait….what……inflation lower ? Yep, that’s right. Forward models using base effects, along with Bloomberg consensus estimates are actually showing a peaking of inflation here – just as the Fed starts to panic about it – and moderating next year in a sequential fashion. This is consistent with the ISM model where the business cycle peaks and starts to decelerate, and tends to bring inflation down with it. No guarantees of course, and we wait to see the data as it comes in, but that’s the outlook.
The market appears unfazed by the quicker end to QE, and rightly so. It is an emergency policy setting that should not be in effect right now based on the stage of the cycle we are in. Rate rises next year however are a different issue, as we believe they are a high probability of running smack bang into the beginning of a slowdown. It is possible they may not even get off the ground at all (or at least significantly delayed) if the market pukes on decelerating growth and inflation data. Early 2nd quarter 2022 is our best guesstimate right now of where that gets serious, but as always, we’ll be data and trend dependant to provide us with the early look. Keep watching the weekly Portfolio Strategy Update, as that is where we will keep you updated in real time.
Author: Graham Parkes
Macro analyst & editor of The SMSF Investor
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