If the ‘January effect’ truly exists and those returns are prelude for the rest of the year, then investors had better put on their crash helmets and strap on their seat belts for the ride in 2022!  Stocks have swooned in the first month of the year, mirroring a similar sell-off that started 2016, coincidentally also a time when the U.S. Federal Reserve started to remove the extreme monetary ease that had existed since the financial crisis in 2008.  But this time around the ‘pivot’ to tighter policies has been much more aggessive as the Federal Reserve prepares to drain liquidity from the financial system to cool the inflation that its policies partially stoked, Wall Street’s pandemic-era party appears to be ending. Stocks, bonds, crypto, you name it—almost every asset class has hit a rough patch since 2022 dawned, and things could get worse before they begin to get better.  The sharpest reality that seems to be setting in for investors is that the so called ‘Fed put’ (where it has rescued market sell-offs with new rounds of monetary easing) might be Ka’put’!

Since 1977, the Federal Reserve has operated under a mandate from Congress to “promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates” — what is now commonly referred to as the Fed’s “dual mandate.”  During the entire period following the Financial Crisis in 2008, the mandate has focused almost soley on the ‘maximum employment’ part of the equation since gorwth was tepid and inflation was basically non-existent.  U.S. M2 money supply has increased an astounding 41% over the past two years. That’s more than twice the pace of monetary expansion following the financial crisis of 2008-09 and substantially greater than the money printing of the inflationary 1970s.   And nowhere has the impact of this easy Fed policy been more apparent than in asset prices, from the doubling of the S&P500 since March 2020, to home prices jumping about 20%, to rampant speculation in newer asset classes such as crypto currencies, NFTs and SPACs.

The Fed maintained this ‘crisis policy’ of zero interest rates and active bond buying during the near-meltdown of markets resulting from the Covid-19 pandemic.  The virus and its variants persist, but the economy has largely recovered, with the unemployment rate under 4% and the labor market beset by worker shortages. Inflation, meanwhile, has soared to 7% from a combination of supply constraints and pumped-up demand.  Following the December Fed meeting and comments by Fed officials, the probability has heightened that the central bank would not only wind down its monthly purchases of treasury and mortgage securities but begin to reduce its holdings, which would tend to drain liquidity and tighten financial conditions.  At the time of the financial crisis, the Fed’s balance sheet was about $850 billion. Today, it is $8.8 trillion. The national debt has surged to $29 trillion, and the debt-to-GDP ratio is close to 1.3 times, both all-time highs. The Fed was reluctant to raise interest rates sooner because it feared derailing economic growth. Also, higher rates raise the interest expense on the national debt.  That narrative has changed and getting inflation under control is the more urgent requirement.  We have had more than a decade of low market volatility, largely because of the large amount of liquidity in the financial system. We are at the start of a multiyear period in which the markets will have to learn to reprice risk, because the consequence of a decade’s worth of extremely easy central-bank policy has been the distortion of prices and the mispricing of risk. The coming period is going to be a more difficult one.

Investors are starting to finally understand that the Fed focus is now this inflation threat.  They recognize that they are ‘behind the curve’ in terms of taming this inflation threat and will need to move more quickly and aggressively than investors had expected prior to the start of this year.  In that way, the idea of a ‘Fed put’ just doesn’t look likely.  More importantly, in terms of income equality, the reality is that stock market investors are mostly from the wealthier portion of the population while inflation, particularly in food and transportation costs, impacts everyone and actually has a disproportionately higher impact on those with lower incomes.  While a 20-25% drop in the S&P500 might lighten the Fed’s resolve to raise interest rates, don’t expect them to come to the rescue of stocks for a 10-15% correction!  At the time of writing, amidst the recent volatility, the S&P500 was down about 8% from it’s peak and the Nasdaq was down 12%, as shown below.  Not a great start to the year for most investors but not yet enough, in our view, to take the Fed of its new tightening path.

The U.S. Fed is not the only central bank that is starting to remove their pandemic eraa easing.  The Bank of Canada echoed the U.S. Fed as they held off hiking interest rates at their January meeting but said that “the economy is now operating at full capacity”, teeing up a rate increase for the bank’s next meeting in March.  They withdrew their forward guidance for rate hikes and made it clear that “emergency economic support is no longer necessary”, indicating that the cost of borrowing will rise in coming months.

1 2