Should the Fed Stay or Should They Go?

07.07.2021 - Douglas Cohen, Portfolio Manager

Should I stay or should I go now?
Should I stay or should I go now?
If I go there will be trouble
And if I stay it will be double
So come on and let me know
Should I stay or should I go?

Jerome Powell was still in his 20’s when The Clash penned those lyrics back in 1982 so it’s conceivable that the future Federal Reserve Chairman once rocked out to what currently constitutes the single most important question for financial markets: should the Fed begin to take away the most powerful punch bowl ever provided?

"Don’t Fight the Fed” Remains as Powerful as Ever
Famed investor Marty Zweig long argued that monetary policy, primarily the trend in interest rates and Fed policy, is the dominant factor in determining the stock market’s direction. That sentiment was crystallized in his oft-cited “Don’t Fight the Fed” mantra.

Zweig probably thought he saw the ultimate manifestation of his thinking via the Fed’s unprecedented response to the 2008 Financial Crisis and the subsequent bull market prior to his passing in 2013. He likely did not imagine that another crisis would soon trigger a Fed response that would dwarf the actions taken in 2008, even if he might have anticipated the same bullish response by the equity market.

Given the dramatic improvement in most market and economic indicators in recent months and the apparent return to near-economic normalcy due to vaccinations, why is the Fed only grudgingly getting to the point where it is “talking about talking” about a plan to adjust the at least $120 million per month in bond and mortgage purchases? Moreover, why is it retaining its guidance that the Federal Funds rate will remain near zero until at least 2023? And, perhaps more importantly, should investors continue to party like it's 1999 or begin to worry about a pullback?

There is an argument that any attempt to tighten monetary policy could unduly rattle markets and a still-tenuous economic recovery (sort of like PTTTSD, Post Taper Tantrum Traumatic Stress Disorder dating back to one of Ben Bernanke’s several ill-fated 2013 attempts to wean the markets from Quantitative Easing).

Should You Believe Your Eyes, or the Fed?
It is important here to separate the signal from the noise. In this case, the official unemployment figures have remained somewhat elevated as many families continue to combat Covid-related challenges, including school closures. Enhanced unemployment benefits have surely played a part as well. Yet, at least in pre-pandemic times, unemployment figures have been viewed as lagging indicators, so perhaps we should look elsewhere for guidance about the Fed’s outlook.

Inflation is the real signal to watch. The recent uptick in most commodities, housing-related prices, food, transportation and pretty much everything else has many investors on full inflation watch even as the Fed insists that the spikes are likely to prove transitory. We tend to agree with the Fed that there are enough technological, demographic, debt and productivity related disinflationary elements in place to prevent a sustained 1970’s style inflation surge.

But there are so many truly unprecedented crosscurrents currently in place that a benign outcome is far from assured. What if the Fed miscalculates and stays super-dovish for too long? As my former Morgan Stanley office neighbor and current Yale Professor Steve Roach recently noted, “the Fed’s inflation myopia is being compounded by zero policy rates, open-ended quantitative easing, and the largest fiscal stimulus in modern history, all while the US economy is now booming.”

Roach believes there is a legitimate risk of a rapid increase in global cost-push inflation, including the confluence of supply-chain congestion (e.g., semiconductors and assorted commodities) and anti-globalization reshoring efforts.

Bubble Trouble Ahead?
Hedge fund legend Stanley Druckenmiller and his family office colleague Christian Broda recently highlighted in a Wall Street Journal op-ed that there are even more significant concerns, notably the further growth of multiple asset bubbles that will inevitably burst.

The duo argued that the Fed’s pedal-to-the-metal monetary stimulus (on top of record levels of fiscal stimulus) at a time when the economy is rapidly recovering from recession is dangerously distorting the true level of interest rates.

In their words, “The federal government has added 30% of GDP in extra fiscal deficits in only two years, right as the baby-boomer retirement wave is beginning to accelerate. The Congressional Budget Office projects that in 20 years almost 30% of all yearly fiscal revenues will have to be used solely to pay back interests on government debt, up from a current level of 8%. More taxes simply won’t be enough to bridge the gap, so pressures to monetize the deficit will inevitably rise over the years…Today’s high stock-market valuations, the crypto craze, and the frenzy over special-purpose acquisition companies, or SPACs, are just a few examples of the response to the Fed’s aggressive policies. The central bank should balance rather than fuel asset prices. The pernicious deflationary episodes of the past century started not because inflation was too close to zero but because of the popping of asset bubbles.”

Druckenmiller and Broda also highlight the Fed’s recent desire to increasingly incorporate social issues such as inequality and climate change into their thinking. Without intending to minimize the importance of those issues, I believe they should fall overwhelming within the domain of the Congress, not the Fed. As frustrating as our political process may be at times, the Fed’s independence from that process is a vital check and balance that we should not endanger, in my view.

Buckle Up for What Could be Bumpy Ride to…Nowhere
Our overall sense is that equity markets will have a rather oxymoronic summer—volatile but range bound—as investors grapple with the Fed’s likely response to incoming economic data skewed by the unique nature of the economic reopening. However, on balance, the Goldilocks backdrop of solid growth, moderate inflation and accommodative monetary policy will likely persist into 2022. By that point, another key “Clash” may emerge.

Watch for a Changing of the Guard
With Powell’s term set to expire next February, will the Chairman want to stick around for another four years? Will President Biden want to install someone of his own choosing? The post 2008 Financial Crisis Fed has generally embraced transparency and a desire to avoid surprises. To the extent Powell is willing and able to serve another four years, we subscribe to the view that the Fed will remain quite dovish into early next year unless the inflation and asset bubble fears escalate significantly from current levels. They may well look to signal the winding down of the current $120 million per month in bond and mortgage purchases as early as this summer, but that should not shock the markets at this point. In accordance with the prevailing consensus view, we believe actual interest rate hikes still seem unlikely for at least the next 12 to 18 months.

This communication is intended solely to provide general information. The information and opinions stated may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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