After decades of loose monetary policy, the Federal Reserve Board has embarked on a mission to tighten credit by sharply raising interest rates. This change has been forced on the Fed by rampant price inflation in everyday goods and services. Many critics of the Fed argue that decades of easy monetary policy (artificially suppressed interest rates) have buoyed asset prices, leading to greater wealth inequality. The Fed has also engaged in quantitative easing, which enabled large government deficits. We agree with the Fed’s critics that such policies went on for far too long and unleashed some of the economic ills being felt today.
Federal Reserve Board policy has provided the fuel for asset bubbles. Long-time Fed chairman Alan Greenspan presided over the meltdown in 2000 brought on by the dot.com mania. Ben Bernanke was Fed chairman when the housing bubble burst in 2007-2008, leading to the financial crisis and Great Recession. And now Jerome Powell is grappling with a market collapse brought on by the highest inflation in 40 years. Only Janet Yellen (chairwoman from 2014-2018) escaped the fallout from loose monetary policy. Using the tool of low interest rates to tamp down every little fire in the stock market has simply resulted in more dry tinder and eventually larger fires.
When inflation in food, energy, airfare, rent, and just about everything that affects daily life started to accelerate in 2021, the Fed attributed the price changes to transitory forces. They said the changes were caused by special factors related to the pandemic and would wind down as bottlenecks in supply chains abated and people returned to the workforce. About one year ago the forecast from the Fed and the futures market was for interest rates of approximately ¼ of one percent by December 2022. Since the Fed controls shorter-term interest rates, it seemed likely that its forecast would become its policy. But we now know that did not happen. Interest rates are more than ten times higher than the forecast of a year ago. The Fed did not want to change its forecast or policy and admit that it had been engaged in wishful thinking. But it has been forced to radically alter policy by inflation that was not transitory, that did not fade away or burn itself out. Instead, inflation has spread more broadly and become hotter, turning into a true inflation conflagration that has burned investors and torched the budgets of lower-income consumers.
Monetary policy and demographics can be viewed as the fuel and dry conditions that made for a combustible economic situation. Add in swirling geopolitical winds and the combination of
forces became even more potent. The conditions for an inflation spike that would force the Fed to abandon its zero-interest rate policy have been present for some time. In retrospect it was the pandemic and policies enacted in response to the pandemic that sparked the inflationary fire. A long fuse was lit when Jerome Powell said in late spring 2020 that the government, through fiscal stimulus (lots of checks in every mailbox) and the Federal Reserve, through monetary stimulus, were going to err on the side of overfilling any economic holes left by the pandemic. We remember thinking at the time that there could be negative repercussions from such aggressive policies, but the only effect for the next 18 months was a robust stock market. The negative implications of filling the economic forest with dry tinder took two years to manifest.
Over the past few months, it has been shocking to see the bond market, usually a paradigm of careful analysis, be so out of step with the change in Fed policy. Bond market investors seem to be in denial about a major shift in Fed policy, and the stock market which now slavishly responds to every up or down tick in bond prices is also in denial. The Fed has clearly lost credibility with investors, because of its repeated pronouncements in 2021 that inflation was transitory, requiring no need to raise interest rates. Investors who once closely followed Fed forecasts now see the central bank as incompetent and unpredictable. Investors are starting to ignore the old Wall Street adage that warns investors to “not fight the Fed.” Fed chairman Powell and numerous Fed governors have felt it necessary to remind investors that the Fed is not kidding; interest rates will keep rising and will stay high until inflation is squelched. A familiar pattern is emerging, of a plunge in financial markets after the warnings, followed by a subsequent rally that does not hold. Bond and stock prices are being reluctantly, slowly, painfully reset to levels that conform to the new regime of higher interest rates.
The bear market of 2022 has been long and drawn out, unlike the bear market of 2020, which was over just weeks after it began. The difference is that this time the Fed has not rescued the market with extremely low interest rates. Instead, almost every asset class is being pulled down by the gravity exerted by high and rising rates. Over the past thirty years when stocks fell into a correction or bear market, other asset classes such as bonds and gold would often gain value. That’s not happening now. There are few, if any, places to fully preserve capital other than cash. Even bonds bought a few weeks ago at yields of nearly four percent have lost a bit of value as inflation numbers remain elevated and interest rates keep climbing.
The pressure on asset prices will not go away until interest rates stop climbing. This reality has not stopped investors from trying to time a bottom in stock prices. A hallmark of bear markets is large, sharp rallies that fade quickly. So far in 2022 there have been 38 trading days where the broad market indices gained or lost more than two percent; in all of 2021 there were only 8 such days. Bear markets rallies can be seductive, offering a salve to wounded accounts. But unless one can tell whether the rally will last for mere hours, a day or two, or maybe several weeks, they can be an invitation for further losses rather than gains.
We have tried to preserve capital by taking profits on our biggest winners from the 2020-2021 period, exiting almost all consumer staples companies and utilities at near record highs, and taking some modest losses on stocks bought late in the bull market cycle. When compared to current prices these sales were generally well-timed and helped preserve client capital. Despite all these protective sales, the remaining, much smaller list of holdings has declined more than we anticipated. Which is another way of saying that we should have “cleared the decks” by selling even more holdings back in 2021 when prices were higher. With stock prices now at much lower levels, the advantage in selling more holdings becomes less. There is less downside to protect from and less money coming in from a sale. Our focus has shifted to finding new positions to lift the equity exposure level of accounts to a similar or higher level than at the start of 2022. It is strategically imperative to have more exposure to equities on the way up than one had on the way down.
For the first time in at least fifteen years the bond market has become dynamic, a daily drama full of risk and reward. The Fed can no longer suppress bond rates as it has done for decades, so the word “reward” can be used again in relation to bonds. There is much to ponder concerning the peak, or terminal, interest rate. Everyone is trying to guess that number: is it 4, 5, or maybe even 6 percent? The eventual bottom in stock and bond prices, gold prices, real estate, and foreign currencies all hinge on that terminal rate. The situation is further complicated by the probability that intermediate-term interest rates could start to fall even as the shortest-term rates rise a bit more. This is called an interest rate inversion and is a common occurrence prior to recessions.
Trying to guess all the different peaks for various bond maturities is impossible. Our goal for clients is to build a laddered portfolio of bonds that spans from 2 to about 6 years, with a bit of longer dated (7-10 year) paper for certain accounts. Rather than making one big guess about interest rates, the laddered bond strategy allows us to make a series of judgements about rates as economic data is reported.