Why the Fed isn’t riding in to rescue markets
Underpinning investor sentiment during the markets’ long bull run from 2010 to 2021 was the psychological safety-net known as the ‘Fed put’. While ultra-low interest rates and massive money-printing exercises set the stage for rising markets, the Fed put (the belief that the Fed - the US Federal Reserve Bank - would step in and boost markets to halt a significant correction) accelerated the rise and played a major role in promoting risky investing behaviour. In the same way that kids feel safe climbing trees and jumping into the sea when their parents are around, investors felt safe taking greater-than-normal risks as they knew the Fed would step in and save the day if investments turned sour.
Everyone knows about the trillions that the Fed printed to prop up markets in 2020 but a better example for right now is what happened in 2017-2018.
Back in late 2017, the US economy and markets were going well, so the Fed started to remove some of the money it had previously injected into markets. It stuck to this policy despite things looking a little shaky early in 2018, but then in December 2018 when the S&P 500 dropped nearly 16% over three weeks, the Fed changed course.
By mid-2019 it had stopped removing money from the system and in October 2019 it announced a new injection of money. Investors breathed a sigh of relief and happily paid higher and higher prices for speculative, unprofitable tech companies and unproven (and fundamentally worthless) asset classes like crypto. The Fed was able to ‘justify’ this, because at the time inflation was still below its target rate of 2% (although only just).
So, is the Fed put off the table?
Yes, at least for now. Unlike in 2018, the Fed can’t print more money to save markets as the consequence is likely to be even higher inflation. And not just higher, temporary inflation but an entrenched upward inflationary cycle that is incredibly hard to bring down again.
What the Fed dreads, as do all central banks, is becoming the next Argentina, Brazil or Turkey — countries where inflation has spiralled out of control beyond the ability of either monetary or fiscal policy to rein it in.
Once people lose confidence in the ability of central banks to control inflation, then they start to bring forward spending (as they know things will cost a lot more next month) and the self-perpetuating cycle continues.
From 2008 to 2021 the Fed printed an extra US$8 trillion without any noticeable impact on inflation. Now, with inflation at levels that many developed countries haven’t seen in decades (8.6% in the US, 9.0% in the UK and expected to be 7% in Australia in December) central banks know that any attempt to prop up markets is likely to feed the inflationary cycle. They know that printing more money will have immediate, serious consequences. Their number one priority is now controlling inflation and stabilising prices — everything else is secondary.
As Fed Chairman Jerome Powell said recently:
“The process of getting inflation down to 2 percent will also include some pain, but ultimately the most painful thing would be if we were to fail to deal with it and inflation were to get entrenched.”
Learning from the contrarian central bank
Most central banks in developed countries are following a similar approach to the Fed — raising interest rates and selling government bonds. But there is one developed-economy central bank that’s following a different approach — the Bank of Japan (BOJ). Despite rising inflation increasing the cost of essentials in Japan (though not at as high a rate as many other countries) the BOJ is continuing to maintain its policy of keeping interest rates at 0.25%. But, it’s finding it increasingly difficult.
On Monday, 20 June the BOJ bought a record US$81 billion in Japanese bonds. This calmed markets, but most analysts see it as a temporary reprieve. The Yen has also collapsed, dropping more than 15% this year to a 24-year low. Hedge funds are shorting Japanese bonds at an incredible rate, knowing it’s almost impossible for them to lose money while the BOJ maintains its 0.25% policy. The BOJ now holds more than 50% of all Japanese government bonds, a record high.
The longer the Japanese central bank maintains its policy against globally rising rates, the more money it has to print, the more the currency falls, and the greater imported inflation Japan will have.
The fact that Japan imports the majority of its food and energy, in a time of very high food and energy prices, makes the falling Yen even more of a problem.
How much of a drop in markets is acceptable to the Fed?
The question that investors most want an answer to is: when will we know we’re at the bottom of the market? How low do markets have to go before the Fed steps in? Of course, nobody knows, but this is really the wrong question. Saving markets is not central banks’ number one concern right now, particularly when their credibility is so under threat. To quote Mr Powell again:
“Restoring price stability is an unconditional need — it's something we have to do. <Price stability is> the bedrock of the economy.”
While we must take these kind of central bank statements with a healthy dose of scepticism, the change in language and priorities is clear. Central banks will not start printing money again while inflation is so high, and we haven’t seen any signs of inflation turning yet.
So, if the Fed doesn’t have your back, then where should you put your money?
For starters, it’s probably a good idea to get off the monkey bars and sit in the sandpit for a while — risk is out of favour. And when risk is more risky than normal then it pays to invest more conservatively. With the market dropping we’re finding plenty of opportunities to invest in well-established, profitable companies with strong recurring earnings at valuations that are a lot more attractive than they were three months ago.
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Since joining IML in 2010, Daniel has been part of the team which won Large Cap Fund Manager of the year in 2012 & 2015. In 2013 he was given Portfolio Management responsibilities within the firm, managing a growing portion of the IML Australian...