The MSCI AC World Index pulled back last week – falling 1.5% as global bonds yields pushed higher. In the United States, the S&P 500 dropped 1.5% while the interest-rate sensitive NASDAQ tumbled 3.9%. The Dow Jones slipped just 0.3% as Value stocks outperformed Growth stocks. European stocks fell 0.8% while Japanese stocks dipped 3.7%. The 10-year U.S. Treasury yield rocketed higher – jumping 32 basis-points – as the Fed signaled a fast pace for balance sheet runoff.
The minutes of the Federal Reserve’s March 16th meeting showed that the Fed intends to allow its balance sheet to runoff at a rate that is double the pace witnessed between 2017 – 2019. If the Fed decides to reduce its securities holdings by $95 billion per month, it will still take the Fed over four years to shrink the balance sheet to pre-pandemic levels.
A former Fed official wrote an opinion piece suggesting that the Fed may need to force U.S. stocks to fall in order to sufficiently weaken financial conditions. However, during the last seven Fed tightening cycles, the S&P 500 was higher at the end of the tightening cycle than at the beginning. A better “sell signal” may be when the Fed decides to stop raising rates with U.S. recessions tending to occur roughly 9-12 months after the Fed ends rate hikes.
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).
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.
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.
|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|
|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|
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).
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.
|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|
|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%|
|Index||Weekly Chg change in percent||YTD year to date in percent||12 Months||Div. Yield division yield in percent|
The Week Ahead
|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%|