This week was one of the most important weeks of the year. We wanted to put out a quick note to try and explain why and what it may behold for the markets for the rest of Q2 and beyond.
On Tuesday the 4th, Lael Brainard, who is expected to be confirmed as Vice Chair to the Federal Reserve soon, and has a reputation as an extreme dove (easy monetary policy) said:
“I think we can all absolutely agree inflation is too high and bringing inflation down is of paramount importance. To do so – the FED will raise rates methodically and as soon as next month, begin to reduce its $9 trillion balance sheet, quickly arriving at a considerably more rapid pace of runoff than the last time the FED shrank its holdings. The rapid portfolio reductions will contribute to monetary policy tightening over and above the expected increases in the policy rate reflected in market pricing and the Committee’s Summary Economic Projections.”
Translation: We are woefully behind the curve and need to raise and tighten much bigger and quicker than we anticipated.
Then on Wednesday the 5th, the FOMC minutes were released from the January meeting, and we learned that the Fed intends to begin to shrink their massive $9 trillion balance sheet by $95 billion per month starting in May and reiterated their objective to rapidly raise rates to fight inflation.
Translation: We are going to raise rates 50bps at the next two meetings (May and June) and begin to sell our massive bond holdings aggressively to fight inflation -which we underestimated.
The Fed, in our opinion, isn’t that worried about the economy being hurt seeing how tight the labor market is and how inflation continues to negatively affect us all.
If they want to get their balance sheet down to a pre-pandemic level of approximately $3.8 trillion, at $95 billion/month it would take a shade over 5 years.
So, the question is can the markets handle this type of liquidity withdrawal? And do the markets even believe it or are they ready to call the Fed’s bluff if we see any kind of dramatic downturn in stocks? (30%+ for example)
The bond markets sure are taking the Fed at their word and have been in disarray for months. Mortgage rates are over 5% and yield curves are inverting/un-inverting on a daily basis. This is helping lay waste to the 60/40 model that is so engrained in current portfolios.
The yield on the 10-year note has risen from 1.62% to the current 2.71% this year.
This week the Fed threw down the gauntlet and now we will see how various markets respond. The fact that the SP-500 has been able to weather multiple bouts of bad news and still is only 6.3% from all-time highs says a lot. But the chart below clearly shows a high correlation to Fed liquidity and stock prices. Does that relationship now reverse course? Or is that just too simple?
We don’t pretend to know, nor do we care to predict. But this week will be looked back upon as a watershed moment when the Fed laid all their cards on the table and waited to see how markets reacted. Was it a coincidence we just finished the first negative week for equities in the last four?
The next few years surely will be remarkably interesting and opportunistic for those ready for change.
