Financial markets will consistently, by design, face internal and/or external hurdles that work to disrupt a sustained uptrend. These hurdles or catalysts can create a minimal amount of volatility in the uptrend at times, though other times, the magnitude of volatility is disruptive to a point where it has far-reaching implications on a governmental and societal level. When disruptions prove beyond ordinary, the Federal Reserve (Fed) may intervene to protect the stability of the American financial economy and value of U.S.-based financial markets.
There is a significant amount of uncertainty at present.
Due to a supply shock in production pipelines of household goods and excess demand for these goods inducing an enlarged supply of money and credit, the U.S. currently faces severe inflation in the price of goods and services (as measured by the Producer Price Index and Consumer Price Index). Energy prices are high and causing significant inflationary pressures. Everything from logistical bottlenecks, labor shortages, wage inflation, and a bevy of other factors and their implications are driving public financial markets to trend downward while volatility increases.
To understand the causes of financial inflation and volatility (along with their current and estimated effects), we need to identify the internal and external catalysts, as well as their root drivers. A past example of an internal catalyst, one originating in the financial system itself, was extremely loose credit standards (abandonment of risk aversion) that resulted in the housing and credit crisis of 2008-09. An external catalyst is, for instance, the COVID 19 pandemic and its impacts on the real economy, financial markets, human interactions, transportation and trade, spiraling price inflation of goods and services, and beyond. The ongoing Russia-Ukraine war and the subsequent diminished supply of oil and gas is also an external catalyst. Understanding how these factors triggered seismic impacts in financial markets is necessary when navigating around them in such turbulent markets.
Interventions by the Fed and Implications for Financial Markets
The stability and equilibrium of the financial activities of producers, consumers, workers, borrowers, savers, and investors collectively determines the health of the financial economy. In a healthy economy, the financial economy trends upward, dealing with normal internal and external challenges along the way. When an abnormal shock to the financial system severely threatens price stability in the financial system, the Fed has historically intervened to stabilize the volatility. The Fed’s “dual mandate” is to maintain price stability while simultaneously maximizing employment. At different points in time (and depending upon the dire needs of the financial system), the Fed’s level of intervention and speed of execution has varied.
Often, the Fed engages with financial markets through press releases of policy decisions and meeting minutes, which elaborate on their views (both individual and collective) on the balance between risk and growth. Recently, the Fed has disclosed their intention to “anchor” inflationary expectations. The next level of intervention involves lowering or raising the Fed funds rate overnight. The Fed can also change the reserve ratios of regulated banks to encourage or discourage lending at the bank level.
Should this method of Fed intervention not work, the Fed actively participates in financial markets in other ways. This is accomplished by injecting liquidity directly into the system, by purchasing high-quality financial securities like government bonds that are intended to not create a loss of principal. This type of intervention is known as quantitative easing (QE). Conversely, when the economy is running too “hot” or demand exceeds supply for goods and services resulting in “price inflation”, the Fed extracts liquidity from the system by performing opposite actions, including (but not limited to) raising Fed fund rates and either selling their holdings into financial markets or allowing them to mature without any subsequent reinvestment of proceeds.
Lessons From History
Understanding the motivations, challenges, and past history of Fed interventions is key when learning how to navigate current market uncertainty. In the decade preceding the COVID-19 pandemic, there were several signs and symptoms of very low inflation, even below the Fed’s 2% inflation target. To thwart that threat, the Fed took an accommodative stance and engaged in several rounds of quantitative easing.
Signs of creeping inflation were welcomed by the Fed. They were confident in their assessment that any inflation would be temporary and transient. To maintain their long-term average target inflation of 2%, they were willing to let current inflation numbers run higher than their target for some time. They were confident that inflation expectations remained “anchored”, as evidenced from public declarations in late 2021 that the apparent inflation was “transitory.” These statements were made despite seeing imbalances in the economy related to supply shocks, as well as excessive fiscal and monetary stimulus payments sloshing around in deposits and financial markets.
By the time the Fed realized in early 2022 that the headline inflation number was spiraling out of control with a strong labor market and signs of wage inflation, the Fed came to the realization that they were behind the curve and needed to act fast to bring down the headline numbers and anchor inflation expectations back at 2%. Abandoning their previous forecasts, the Fed broadcasted their new resolve and new actions of aggressive rate hikes. It has since been made evident that the Fed waited too long to raise rates to rein in inflation despite seeing demand and supply imbalances in the economy, as well as the price inflation of real and financial assets purchased with the pandemic stimulus (direct personal, PPP, the Fed’s own monetary policy).
A Fed-Induced Downturn
Presently, to combat inflation, the Fed has resolved to slow down the economy and deflate asset valuations until it believes it has satisfied the “dual mandate” explained earlier. (This has, in turn, seen increasing unemployment as a side effect). As the Fed does not directly control supply chains, energy supplies/prices, or wages, they need to curtail consumption and investment demand for everything in the short run. To achieve “price stability,”, they will aim to execute their actions of raising rates consistently and significantly, engaging in quantitative tightening to reduce liquidity in the financial system and actively broadcasting their hawkish stance for higher rates.
If the current actions do not appear to yield immediate results, the Fed will employ additional mechanisms until they are sure that the economy gets into a price stable position with the balance of risk and growth becoming neutral. They could overdo everything to control inflation rather than underdo to protect their credibility while attempting to turn the tide of inflation.
Investing During a Fed-Induced Downturn
For all practical purposes, investors should keep a keen lookout for upcoming economic indicators. Good news for the economy can be bad news for the Fed if it stokes more inflation, which will subsequently cause them to aggressively raise rates to taper down financial activity. So long as the real and financial economy appears strong to the Fed while inflation is high, the Fed will continue to raise rates and participate directly in financial markets to extract liquidity out of the financial system. A string of bad news for the economy, which should reduce inflation, will provide relief to the Fed that their actions are succeeding, provided the economic slowdown doesn’t risk a recession so severe that unemployment becomes a major concern.
It is helpful to assess where we are in the Fed cycle. This will help formulate the investment thesis of which financial markets, asset classes, and other factors will do well in the current and future circumstances with anticipated actions of the Fed and other major market influencers taken into account.
Not all investments that previously performed well will continue to do so in the future. Previously, the Fed was controlling volatility, reacting to limit major market dislocations, and public markets performed well given the conditions, but equities are now down in price for the year.
For investment opportunities fit for the current environment where the Fed is engineering a downturn to control inflation, it would be prudent to consider investments that would be hurt the least or benefit most from elevated volatility. These include floating interest rates, short-term, high dividend paying, low beta, high yielding, structured products (volatility benefitting), and debt capital opportunities in private markets that are less correlated with public financial markets. Such private market investment opportunities are not only a strong alternative for generating high returns, but also good from a diversification perspective.