The Schizophrenic Fed
Recent equity market trading has been characterized by extreme directional moves and dramatic intraday reversals. Losses have been suffered across the board. Equity and bond market volatility indexes have both been surging. Broad market sentiment measures have utterly collapsed. In a broad array of assets, the orderly price action and trading structures of past months have turned decidedly disorderly.
Market breadth has been a negative all year. As an example, according to Bloomberg, of the 3,765 stocks in the Nasdaq, just five account for 71% of the index’s 19% year-to-date gain. Outside of the handful of stocks carrying the market, the number of stocks trading at new 52-week lows is dwarfing the number of stocks making new 52-week highs. After a significant but brief improvement in October, breadth measures have been plummeting again. Typically, in these sorts of breadth dynamics, it isn’t the few that pull higher the many, but rather the many that eventually drag down the few. Often in spectacular fashion.
December is supposed to be the magical month of the “Santa Clause rally” where no market risk taking is naughty, and all risk is rewarded as nice. So far, however, the first three days of this December have been, for stocks, the worst start to any December for nearly 20 years. In fact, given the extent of the extremely oversold technical conditions and excessively negative sentiment, at least a short-term bounce in markets should be expected shortly. All in all, in addition to newly ballooning covid concerns, an increasingly schizophrenic market is reflecting an increasingly schizophrenic Fed.
For nearly a year, in response to the Covid pandemic, unprecedented levels of ultra-accommodative monetary and fiscal policy measures were implemented in the US and around the globe. By April of 2021, the Consumer Price Index (CPI) measure of inflation reached 2.6%. The April CPI print represented a meaningful creep above the previously stated 2% Fed inflation target. In light of inflation readings surpassing the Fed target, voices of concern emerged in greater volume outside the confines of Fed headquarters. The question was, is the Fed instigating an inflation problem?
The Fed’s answer was no. Since April, however, inflation has turned from a creep higher to a trending surge that has brought us to our most recent 6.2% year-over-year CPI reading. All along the way, Chairman of the US Federal Reserve Jerome Powell, US Treasury Secretary and former Fed chair Janet Yellen, and other members of the greater Fed family have defended their policies by stubbornly insisting that the inflation pressures building in the economy were merely transitory.
On Tuesday of this week, however, Fed Chairman Powell gave up some ground and finally said that the word “transitory” would be retired in terms of describing inflation. Treasury Secretary Yellen chimed in as well to say, “I’m ready to retire the word transitory. I can agree that that hasn’t been an apt description of what we’re dealing with.” While neither the current nor former Fed-heads announced a definitive reversal to the Fed’s long-held dismissive position on inflation, the backing away from transitory was significant and inflamed a building crisis of confidence in Fed economic management.
After encouraging markets to dismiss inflation concerns for months, in his testimony to congress this week, Powell said, “…policymakers need to be ready to respond to the possibility that inflation may not recede in the second half of next year as expected.” Powell added that “The risk of persistently higher inflation has clearly risen…” and “…it now appears that factors pushing inflation upward will linger well into next year.”
Powell went on to say that, “At this point, the economy is very strong and inflationary pressures are higher, and it is therefore appropriate in my view to consider wrapping up the taper of our asset purchases, which we actually announced at the November meeting, perhaps a few months sooner…. I expect that we will discuss that at our upcoming meeting.”
The news of the retirement of the word transitory and the floating of a possible accelerated taper schedule, absorbed together, stunned an unsuspecting market. The news was all the more shocking coming hot on the heels of dovish comments Powell made the previous day regarding the new Covid omicron variant. Speaking on the latest Covid scare, the Fed Chairman seemed cautious in highlighting omicron’s threat to the economy and specifically to the Fed’s employment mandate. Markets had assumed that the escalating threats posed by the recent surges of both the delta and omicron Covid variants would act to keep the Fed accommodative and to slow any Fed actions toward policy normalization. Not so, apparently. After the hawkish Fed revelations, the market embraced a decidedly risk-off tone.
Along with Powell and Yellen this week, the hawkish floodgates seemed to open for just about everyone associated with the Fed. Numerous voices were out this week supporting the notion that both the tapering of Fed asset purchases and possible plans for future rate hikes need to be accelerated.
Randy Quarles, who is stepping down as a Fed governor this month, was one of those voices. In a Bloomberg interview this week, Quarles referred to inflation as being at “stratospheric levels” and said, “I certainly would be supportive of a committee decision to move the end of the taper forward from where people had been expecting it….” With regard to the transitory inflation narrative, Quarles said that it had become clear in recent weeks that it was no longer a reasonable base-case scenario. In a webinar hosted by the American Enterprise Institute this week, he said, “This is…not really a bottleneck story anymore….” Quarles went on to suggest that to subdue inflation, overheating demand within the economy needs to cool-off to help bring the supply/demand fundamentals back into balance. He went on to say, “Therefore, we should respond more quickly to constrain that demand….” In addition to the accelerated taper, for Quarles, that means raising interest rates. In his Bloomberg interview, Quarles said, “If we get to next spring and inflation is still over 4%…and we’ve ended our taper…we need to start using other tools.”
Meanwhile, Former president of the New York Fed Bill Dudley, in a Bloomberg interview this week, said the Fed is behind the curve on inflation. Dudley went on to explain that, in his view, the ramifications of such a behind-the-curve policy misstep will have consequences. Referring to future interest rate hikes, Dudley said, “The Fed will probably have to go faster than what people expect, they’ll probably have to go higher than what people expect, and that’s going to be a bit of a shock to financial markets.”
What does Dudley mean by the understated description of “a bit of a shock?” Well, the former NY Fed president went on to say, “The market is going to have to be significantly repriced at some point.” While the comment “significantly repriced” is ambiguous on direction, it’s certainly safe to assume he did not mean higher.
For those long skeptical of the Fed’s perfect wisdom and total clairvoyance, a hawkish policy pivot towards acknowledging and attempting to address a significant inflation issue is not surprising in and of itself. What is more surprising is that the timing of tough talk towards reducing market support is coinciding with a renewed round of serious Covid concerns along with continually deteriorating problems in China, Turkey, and increasingly across the emerging market periphery more generally. Considering the degree to which markets have evolved to take an all-powerful Fed’s constant market support for granted, it’s no wonder markets are reacting to a hawkish Fed with panic, confusion, and extreme volatility.
To contemplate the extent to which markets have evolved toward being ever more Fed-centric, consider a note out this week from Bank of America. BofA estimates that, prior to the 2008 financial crisis, corporate earnings drove half of all equity market returns. Since the crisis, however, as the Fed has dramatically escalated its active economic management, BofA estimates that corporate earnings explain only 21% of returns. Since 2010, the bank estimates that changes to the Fed’s balance sheet now alone account for 52% of market returns. In other words, the Fed’s balance sheet has far surpassed corporate earnings as the dominant driver of markets. Indeed, in our modern markets, the price-to-earnings multiple has really been eclipsed by the QE multiple.
Keep in mind that all of this exploding cross-market angst and uncertainty is taking place in an equity market trading at record high valuations. A newfound fear of heights is unsettling when on top of a one-story building. It is, however, an entirely different brand of terrifying when peering over the edge of a valuation skyscraper.
On the basis of ratios for price-to-sales and the “Buffet Indicator” of price-to-GDP, US equities have never been more expensive. Just this Friday, according to the Australian Financial Review, Warren Buffet’s closest partner and vice-chairman of Berkshire Hathaway, Charlie Munger, described the current wildly overvalued markets as being “…an even crazier era than the dotcom era.” Much of that high valuation has been built upon the rock-solid market buy-in to the strength of, and certainty in, an ever-present “Fed put.” If faith in that put proves to be misplaced, the ensuing significant repricing spoken of by Bill Dudley could be exceedingly unpleasant. This week, the team at the Elliot Wave Financial Forecast put it best. Under a scenario where the Fed can’t support markets, “The era of space flight for financial assets is over. Only a long and treacherous re-entry to earth remains.”
With the changeable, schizophrenic Fed witnessed of late, it’s anyone’s guess as to which way the next round of Fed messaging might go. That said, markets appear to be increasingly alert to the possibility that a significant Fed policy change may be underway. Recent market behavior suggests that unless that policy can effectively navigate the minefield, risk assets will not take kindly to a Fed policy error.
As for weekly performance: The S&P 500 closed the week down 1.22%. Gold was lower by 0.09%, silver lost 2.73% on the week, platinum dropped by 2.94%, and palladium rebounded slightly from last week’s clubbing, up 1.76% this week. The HUI gold miners index lost 3.96%. The IFRA iShares US Infrastructure ETF was lower by 1.47% for the week. Energy commodities continue to be under pressure. WTI Crude Oil lost another 2.77%, while natural gas crashed 24.56% on the week. The CRB Commodity Index was off 3.17%, while copper was down 0.49%. The Dow Jones US Real Estate Index ended the week down 0.40%, while the Dow Jones Utility Average Index was up 0.78% on the week. The US Dollar Index was flat this week, up by 0.01% to close the week at 96.11. The yield on the 10-year Treasury dropped by 13 bps to close the week at 1.35%.
Have a great weekend!
Chief Executive Officer