Too Much or Not Enough?

The big news last week was the release of the March 16th Federal Open Market Committee (FOMC) meeting minutes which outlined the Fed’s plans for balance sheet reduction. The minutes showed that all participants agreed that elevated inflation and tight labor market conditions warranted commencement of balance sheet runoff at a coming meeting. Signs point to a pace of decline in securities holdings that is twice the rate of the 2017-2019 drawdown.

Participants generally agreed that monthly caps of about $60 billion for U.S. Treasury holdings and about $35 billion for agency mortgage-backed-securities (MBS) would likely be appropriate. These caps would be phased in over a period of three months or modestly longer if market conditions warrant. At this pace, the Fed would be allowing a little over $1.1 trillion of bonds to roll off the balance sheet each year. That sounds traumatic, but the Fed increased its bond holdings by about $4.8 trillion in just over two years – meaning it will take over four years to normalize the balance sheet to pre-pandemic levels (see figure 1).

This chart shows the Fed’s Reserve Total Assets in Trillions of Dollars from January 2010 to January 2022.

Importantly, financial markets have never seen this pace or scale of balance sheet reduction. In 2018, which was the last time the Fed reduced its balance sheet while raising interest rates, U.S. equities fell about 6.2% (see figure 2). Although we should note that this was also the height of the U.S. – China trade war with the countries constantly ratcheting up retaliatory tariffs. Absent the trade war, U.S. stocks may have fared better. Though we should also highlight that there was substantial fiscal policy at the time as well with President Trump’s Tax Cuts and Jobs Act materially lowering U.S. corporate taxes. As such, that period likely doesn’t provide investors with the best historical precedent.

This line chart shows S&P 500 versus Federal Reserve Total Assets in Trillions of Dollars from January 2010 to January 2022.

Do Stocks Have to Fall for the Fed to Succeed?

Bill Dudley, Former President of the Federal Reserve Bank of New York, ignited a debate last week when he published a Bloomberg opinion piece on April 6, 2022 called, “If Stocks Don’t Fall, The Fed Needs to Force Them.” Dudley argued that Fed Chair Powell stated in his March press conference that, “Policy works through financial conditions. That’s how it reaches the real economy” and that the U.S. economy doesn’t respond much to short-term rates and most U.S. homeowners have fixed-rate mortgages. Therefore, to tighten financial conditions, the Fed needs to either raise rates much higher than they are currently signaling or needs to shock markets into believing they will, which could bring down equity markets and tighten financial conditions (see figure 3).

The argument does make some sense, but history suggests that it may not be easy to do nor necessary. During the last seven Fed tightening cycles, the S&P 500 has continued to rise during each tightening cycle – rising an average of 14.7%. The weakest return was 9.0% (mid-1990s) and the strongest was 28.8% (late 2015 to early 2019). During those seven tightening cycles, five of them eventually ended with the U.S. economy falling into a recession roughly 9-12 months after the Fed stopped tightening (see figure 4). That is the traditional lag time between monetary policy and the real economy. Think about it like steering the Titanic. You may see an iceberg ahead, but it takes time to change direction. Sometimes the captain avoids the iceberg, but sometimes not.

This line chart shows U.S. Financial Conditions Index versus Periods of U.S. Recession from 1991 to 2022 year-to-date.

Fed Tightening Period			Fed Funds			S&P 500			NBER First Recession Month	Number of Months Recession Occurred After The Start of Tightening	Real GDP Drop (%)	Policy-Induced Recession?
Start	End	Type of Cycle	Start	End	Chg Change in FF (bps)	Start	End	% Chg Change
Sep-65	Nov-66	Slow	4.02	5.76	174	89.38	80.99	-9.4%	--empty	--empty	None	No
Jul-67	Aug-69	Fast	3.79	9.19	540	93.01	94.18	1.3%	Jan-70	30	-0.6%	Soft-ish landing
Feb-72	Jul-74	Fast	3.30	12.92	962	105.24	82.82	-21.3%	Dec-73	21	-2.7%	Hard landing
Jan-77	Apr-80	Fast	4.61	17.61	1300	103.81	102.97	-0.8%	Feb-80	37	-2.2%	Hard landing
Jul-80	Jan-81	Fast	9.03	19.08	1005	119.83	132.97	11.0%	Aug-81	12	-2.1%	Hard landing
Feb-83	Aug-84	Slow	8.51	11.64	313	146.80	164.42	12.0%	--empty	--empty	None	No
Mar-88	Apr-89	Fast	6.58	9.84	326	265.74	302.25	13.7%	Aug-90	28	-1.4%	Soft-ish landing
Dec-93	Apr-95	Fast	2.96	6.05	309	465.95	507.91	9.0%	--empty	--empty	None	No
Jan-99	Jul-00	Fast	4.63	6.54	191	1248.77	1473.00	18.0%	Apr-01	26	-0.1%	Soft-ish landing
Jun-04	Jun-06	Fast	1.03	4.99	396	1132.76	1253.12	10.6%	Jan-08	43	-3.8%	Monetary Policy Not Primary Driver
Oct-15	Jan-19	Slow	0.12	2.40	228	2024.81	2607.39	28.8%	Mar-20	53	-10.1%	Monetary Policy Not Primary Driver
Average			4.06	9.64	522	526.92	618.37	6.6%	N/A	31	-2.9%	N/A

This table has data that describe Past Fed Tightening Cycles versus Economic and Market Performance over several time windows from 2006 to 2019.

We remain hopeful that the Fed’s steering will be nimble, but we are doubtful that the Fed will be able to materially bring down equity markets unless investors believe that a U.S. recession is dead ahead. We do not appear to be there yet with many investors believing that there is still time to engineer a soft landing for the U.S. economy. What does this mean? It might indicate that investors could be better off trimming positions if the Fed decides to pause (or cut) rates instead of hiking. It would likely be a clearer sign of a recession dead ahead than what we are seeing today with initial jobless claims, or claims for unemployment insurance, at just 166,000 – a level last seen in November 1968. If a recession were dead ahead, we would likely be seeing a rise in jobless claims, which tend to trough about 13 months prior to a recession (see figure 5).

This line chart shows Initial Jobless Claims versus Periods of U.S. Recession from 1958 to 2022 year-to-date.

Seeking to Maintain a Defensive Portfolio Tilt

We think that investors should consider being defensive with portfolios tilted towards high quality dividend-growing stocks, consumer staple stocks, global pharmaceuticals, a mix of natural resources stocks (energy, agriculture, precious metals), and a blend of intermediate-duration fixed income. We think it’s too early to materially trim equity positions.

What Should U.S. Investors Watch in the Week Ahead?

Investors will be keyed in on the March consumer price index which will be released Tuesday with the consensus calling for prices to rise from 7.9% year-on-year to 8.4% year-on-year. While prices continue to rise, we have been encouraged recently with used car prices starting to ease and West Texas Intermediate crude oil prices having come down over 23% since its March 8th high. Other commodities have not seen that sharp of a decline, but any downtrend in prices is welcome news. While the Fed is normally the economy’s steward, it seems like inflation is the captain now.

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Index	Weekly Chg change in percent	YTDyear to date change in percent	12 Months 12 month change in percent	Div. Yield division yield in percent
Dow Jones	-0.3%	-4.5%	3.6%	1.9%
S&P 500	-1.3%	-5.8%	9.5%	1.4%
NASDAQ	-3.9%	-12.4%	-0.9%	0.7%
Instrument	Weekly Chgchange	YTDyear to date	12 Months12 month change	Level
10-Year Treasury Yield (%)	31.7 bps	118.9 bps	108 bps	2.70%
Gold ($/Oz.)	1.1%	6.5%	10.9%	$1,947.5
Oil ($/bbl)	-1.0%	27.6%	64.9%	$98.26

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This table shows returns for various USA equity markets and select assets, in weekly, year-to-date and 12 month changes.

Index	Weekly Chg change in percent	YTD year to date in percent	12 Months	Div. Yield division yield in percent
Global	-1.5%	-7.0%	1.4%	1.9%
Europe	-0.8%	-8.9%	-2.7%	2.8%
Japan	-3.7%	-12.1%	-14.0%	2.3%
Emerging Markets	-1.5%	-8.1%	-14.2%	2.5%

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This table shows the US Stock Market Returns and Select Assets and International Stock Market Returns.

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Date	Time	Event	Period	Consensus	Prior
4/12	6:00	NFIBNational Federation of Independent Business Small Business Optimism	MarMarch	95.0	95.7
4/12	8:30	CPI Consumer Price Index YoY year on year	MarMarch	8.4%	7.9%
4/12	8:30	CPIConsumer Price Index Ex Food and Energy YoY year on year	MarMarch	6.6%	6.4%
4/14	8:30	Retail Sales Advance MoMMonth over Month	MarMarch	0.6%	0.3%
4/14	8:30	Retail Sales Ex Auto and Gas	MarMarch	0.0%	-0.4%
4/14	8:30	Initial Jobless Claims	4/9/2022April 9, 2022	171k thousand	166k thousand
4/14	10:00	U. of Mich. Sentiment	AprApril P	59.0	59.4
4/15	9:15	Industrial Production MoMMonth over Month	MarMarch	0.4%	0.5%

This table lists a number of key economic events, analysis reports and forecasts from influential institutions.

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