With Federal Reserve on a Roller Coaster Ride
How Fed Decisions Swing Equities
Federal Reserve System, the central bank of the United States, is responsible for conducting national monetary policy. It has a dual mandate: maximum employment and price stability while maintaining interest rates at moderate levels. The Fed aims to keep inflation in check as it targets a 2% annual inflation rate. To maintain these mandates, the Fed utilizes various monetary policy tools and methods such as:
Fed Fund Rate
Fed Fund Rate is set by Federal Open Market Committee (FOMC), which sets the direction of the monetary policy. This is the rate at which banks borrow. When the Fed raises its fund rate, it raises the borrowing cost for banks, which, in turn, elevates the cost of borrowing for businesses and consumers leading to economic slowdown as borrowing decreases and economic activity shrinks. On the other hand, when the Fed lowers the Fed fund rate, the bank can borrow at cheaper rates, leading them to lend it further at cheaper cost. Businesses and consumers should be in a better position to grow as they can borrow money cheaply. This should lead to economic growth.
Quantitative Easing and Quantitative Tightening
Another tool that Fed uses is expanding or shrinking its balance sheet in programs known as Quantitative Easing (QE) and Quantitative Tightening (QT)
Quantitative Easing
Quantitative Easing refers to large asset purchasing programs conducted by the Federal Reserve. It is a phase where the Fed wants to inject money into the economy. It does so through purchase of securities and expanding its balance sheet by increasing its assets. As there is more money floating around, more lending will occur which should lead to an increase in economic activity and reduction in interest rates. However, if done excessively, this could lead to rising prices resulting in higher inflation.
Quantitative Tightening
Quantitative Tightening refers to a phase where the Fed is aiming to reduce money flow in the economy. It does so by shrinking its balance sheet or reducing its assets. As there is less money circulating around, there will be less lending by the banks resulting in slowing economic activity as borrowing becomes more difficult and interest rates rise.
To comprehend how changes in monetary policy get reflected in the equity market, let’s take the last 15 years and observe how Fed decisions caused dramatic moves in equities. These years have been divided into 3 parts.
2009–2019
This was the era of extremely low interest rates. Fed fund rates were kept around 0% and the consumers and businesses were borrowing at historically low rates. To stimulate the economy from the wakes of financial crisis of 2008, the Fed used both tools. It cut interest rates to zero and since the economy required more stimulus, it implemented quantitative easing (QE). Its assets rose from approximately $900 Billion in Sep 2008 to a peak of around $4.5 Trillion in Dec 2014. The interest rates were then raised gradually to around 2% and the balance sheet was reduced steadily to $3.76 Trillion in Sep 2019, but the market had shown resilience. This was considered a low-rate environment characterized by elevated borrowing and growing economy.
Borrowing at such a low rate plus Quantitative Easing (QE) spurred spending by consumers and businesses. Consumers were spending and businesses were expanding as borrowing cost was low. Growth funds were seeing an elevated cash flow and valuations were skyrocketing. Gross Domestic Product (GDP) was growing steadily and the risk on environment led investors to pile into equities.
The result was obvious, a decade long secular bull market where S&P500 increased five-fold from around 667 in Mar 2009 to approximately 3394 in Feb 2020
2020–2021 (COVID-19)
During the outbreak of the pandemic, economic activity was hit hard, restrictions were put in place that essentially affected millions of businesses. This was a short-term issue, yet a severe one. GDP shrank for two consecutive quarters with the second quarter dropping at an annual rate of around 30%, making it the most severe GDP decline in modern history. The Fed intervened by lowering its fund rate to zero. However, there was not enough cushion to support the economy by merely going from 2% to zero, so the Fed applied quantitative easing (QE). The increase of money supply was extreme as Fed assets jumped from $3.76 Trillion in Sep 2019 to around $9 Trillion in March 2022. That excess increase of balance sheet did not go unnoticed as the GDP grew by more than 33% in the subsequent quarter on an annualized basis and market marked a sharp V-shaped recovery.
This boosted the economy and the markets, but a problem emerged, Inflation. Excessive quantitative easing, together with other factors such as supply chain constraints, resulted in elevated prices that were feared to remain persistent and called for a quantitative tightening (QT) that started in 2022.
2022-Present
The first interest rate was not raised until FOMC meeting in March 2022, but the markets started its bear market journey since the beginning of the year. Stock market is a discounting mechanism and unlike the economy, which sees the effects of monetary policy with a lag, the effects of Fed decisions can be observed on the market almost immediately. In fact, with strategies like forward guidance that the Fed implements, the market can anticipate and react to the changing Fed dynamics earlier. Forward guidance is a communication strategy that the Fed uses to set the stage for its future monetary policy. Rate hikes that started in March of 2022 were communicated earlier and hence was expected by investors.
From March 2022 till May 2023, the Fed has raised its fund rate 10 consecutive times bringing it from zero to 5%-5.25% in a combination of 25, 50 and 75 basis points rate hikes. It has also reduced its assets from approximately $9 Trillion in June to around $8.5 Trillion by the start of May 2023. The effects of that were felt by the market as S&P500 dropped by around 20%. Although some still praise the resiliency of the market given the negative news from geopolitical tensions, to supply chain constraints to Fed excess rate hikes, it remains obvious that those factors did play a role in defining the market downturn.
It takes time for the Fed decisions to be fully observed in the economy. What started in March 2022 has shown its effects on the economy slowly. Inflation started its downward journey, but it did not come without economic pain. Borrowing costs rose for consumers and businesses. Credit card loans, for example, were hovering north of 20% in May 2023. This led to a rise in credit lending standards and restrictions on credit. Consumers and businesses were not able to borrow as freely as before, and the economic activity took a hit.
In times like these, corporate earnings start their downward trajectory as sales drop and profit margin dwindle. Businesses find it difficult to expand resulting in further slowdown. Fundamental metrics such as price per earnings start to look unattractive and the sell-off exacerbates. This is especially true for growth stocks with some dropping by more than 70% from their all-time highs. Cyclicals, that are sensitive to economic conditions, suffered a hit as well.
Investors, already panicked at the economic downturn and shrinkage of profit margins, might find it reasonable to park their money in cash. Others might just want to take advantage of higher yields offered by interest paying instruments. An already troubled equity market takes a further hit as influx into fixed income assets results in further sell-off.
Apparently, whether it was the boom of the pandemic or the bust of 2022, equity roller coaster ride has proven the influence Federal Reserve decisions have on the markets. Equity market tends to perform well during low interest rates and when QE is in place, and its performance deteriorates during high interest rate environment where monetary policy is tightening. In 2013 Berkshire Hathaway Annual Meeting Warren Buffett said: “Interest rates are to asset prices, you know, sort of like gravity is to the apple. And when there are very low interest rates, there’s a very small gravitational pull on asset prices.”
It is crucial to understand the dynamics of Fed decisions and how they impact your portfolio. Strategies could be put in place that favor a certain outcome. Although it might be extremely difficult, if not impossible, to know the exact movement of the stock market, knowledge about economic headwinds and tailwinds could be beneficial in positioning your portfolio. It increases your chances of profit and reduces your loss potential. Even if you take longer term view, being able to navigate the shifts in Fed stance should offer peace of mind and possibly a better exit point in the future.
