Don’t Fight the Fed

by John R. Stewart, Senior Financial Advisor/Portfolio Manager | Aug 25, 2022

“Don’t Fight the Fed” is a fundamentally sound approach when it comes to deciding when to buy or sell equities and bonds. It seems that when the Federal Reserve is accommodative with lower interest rates and easy monetary policy, the stock market and bonds rise in price.

The exact opposite occurs when the Federal Reserve starts to tighten by raising interest rates and taking money out of the economic system. Just the mention of higher interest rates can cause the market to deteriorate very rapidly. Case in point was October-December 2018 when Fed Chairman Jerome Powell said that the Fed was going to raise rates four or five time in 2019. The market dropped 30% during that timeframe and just like that on December 25^th Mr. Powell said “whoops, I don’t think we will raise rates at all in 2019” and the market immediately turned, and we were on a tremendous bull market which lasted until January 4, 2022.

The Fed has dual Congressional mandates which dictates their policies. First is to have United States at full employment (considered to be around 5% unemployed) and second, to have inflation no greater than 2% per year. While unemployment has been historically low since the Covid induced shutdown, inflation has gone out of control (reaching a recent record of 9.1% in June).

Now the Fed seems serious about stopping the raging inflation rate and they have started raising short term interest rates as well as draining liquidity from the marketplace. A bear market (a drop of 20% or more) quickly ensued for all of the major market indexes. The “Death Cross” (when the 50-day moving average crosses the 200-day moving average) of all of the indexes occurred earlier in 2022.

The Fed has drained $116 billion of liquidity from the market since April 19^th.  The Fed’s quantitative tightening is expected to double next month with $60 billion in Treasuries and $35 billion in Mortgage-Backed Securities being allowed to runoff. and it is widely expected the Fed will raise rates at its next meeting, but it now appears they may be tapping the brakes of liquidity to fight the inflation they help to create. The 10-year treasury yield ended the week at 2.989% and growth stocks with lots of debt typically do not do well in a rising rate environment.

The US Debt Clock shows that the interest paid on the record $30.7 trillion of debt could exceed the US federal tax revenue if rates exceeded 3.5%. While the Fed is in charge of our monetary policy, Congress is in charge of fiscal policy and just since the start of the Biden administration, over $4.5 trillion of debt has been added to our deficit.

The Fed has painted itself into a corner and will inevitably have to continue to print “fake” money because it can’t afford to raise rates above 3.5%. Where would growth come from if all federal tax revenue went to servicing our $30-plus trillion debt? We could already be in a life-changing recession with high inflation, and that kind of stagflation could be challenging for people who believe the narrative coming from Washington.

While the Fed’s next FOMC meeting isn’t until September 20-21, we’ll get a chance to hear from Fed Chair Powell this week when he gives a speech at the Jackson Hole WY conference on Friday, August 26. Traders will be listening to every word Mr. Powell has to say to glean any insight on how big they’ll raise rates in September, along with any hints on what comes after that, as we have 2 more meetings the rest of the year on November 1-2 and December 13-14.

There’s been plenty of debate on how high the Fed will raise rates. Will they do another 75 basis points? Or scale that back to 50 basis points?

Even though the Fed has been consistent in their messaging that they will continue to raise rates until inflation goes meaningfully lower (i.e., on its way back down to 2%), traders have remained skeptical of their resolve.

One look at the 10-year Treasury yield shows this doubt. Just prior to the Fed’s July meeting, when they raised rates by 75 basis points, the yield hit a high of 3.483. But since then, it has fallen to a low of 2.618. That is a decline of 24.8%. It has bounced off its lows and is now at 3.037. That’s closer to the level previously floated by the Fed when they said that expect to see the Fed Funds rate between 3-3.5% (the midpoint is at 2.38% now) by year’s end. With yields back on the rise, it looks like traders are starting to believe it.

The Fed’s plan to address inflation may be to remove liquidity, significantly slow the economy and lower consumer demand. Time will tell whether we will have a soft or a hard landing. Twelve years of Fed-induced liquidity injections producing a bull market in stocks and bonds may be unwinding before our eyes.

As investment mangers we will be watching what the Fed not only says but does over the next several months. When the Fed indicates that they have achieved their goals and will stop raising rates that should give us the “green light” to come off the sideline and get back in the game. Eventually inflation will be tamed one way or the other and the headwinds we are now facing will abate. The economy will once again flourish, the stock and bond market will bottom, and a new bull market will emerge. But for now, CASH is king and always remember: “Don’t Fight the Fed”.

This article represents the opinion of John R. Stewart as of August 23, 2022. John R. Stewart is an investment advisor representative with Physicians Wealth Solutions, LLC, a registered investment advisor. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risks and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial advisor and/or tax professional before implementing any strategy discusses herein.