Week Ahead: Is The Fed About To Send Stocks Lower?

Predictions are hard and predicting the stock market, with its myriad moving parts and multiple, disparate influences, would be especially tricky, but that is not the case in the long term. The economic system that we live under is inflationary, meaning that asset prices are effectively pre-programmed to rise over time.

On the other hand, short term predictions are generally harder, and have been even more so over the last ten years as the Fed has distorted the bond market. There are signs that that distortion is coming to an end, but are the Fed about to replace distortion with dislocation, and send stocks tumbling in the process?

I should say that I am not a Fed hater who lays the blame for any economic woes at their door. It would seem that over the last eight or nine years the Fed has done a remarkable job in keeping the U.S. economy moving forwards in the face of a lack of political will to stimulate fiscally and deflationary threats around the globe.

What the Federal Reserve Bank has done over the last few years may well have been necessary, but it has clearly resulted in massive distortion.

Capitalism depends on free markets. That doesn’t mean unregulated markets; it simply means that pricing based on supply and demand is used to allocate capital. What we have seen over the last decade is a series of moves by the central bank such as zero interest rates and massive purchasing of bonds that have affected that.

Financial institutions have basically been handed a bunch of free cash to invest and that has had several effects. The most worrying of those is a reduction in risk aversion. Investment risk is judged against a baseline derived from prevailing interest rates and when those rates are zero the relative risk in all investments is reduced.

Even over the last couple of years, as the Fed has wound QE down to zero and begun a gradual “normalization” of rates, things have not returned to normal. The Fed still has an enormous amount of assets on its books and while they have not been actively buying more for a while, neither have they been selling them.

In effect, they have shrunk the overall size of the bond market, creating a scarcity that pushes prices up and therefore yields (interest rates) down. Last week, the minutes from the last FOMC meeting suggested that they might start to sell those assets, and that was confirmed overnight by St. Louis Fred Chair James Bullard.

The FOMC feels that selling those assets may push interest rates up naturally, reducing the need for hikes in short term rates in the future. The problem is that there is no way of knowing how drastic the effects of unwinding this massive position will be, if for no other reason that it has never been done before on this scale.

Given the market’s tendency to anticipate, there is a good chance that it will have a much more dramatic effect than desired and interest rates will jump in anticipation of the move.

Now, it is of course possible that fiscal policies such as tax reform and a stimulus package will make the jump in interest rates that could result from the Fed’s asset sales not just less dangerous, but actually desirable as a bulwark against inflation. For now, we have no idea what such policies would look like, and based on the failure of the healthcare bill, there must be some doubt that tax reform or stimulus packages will come at all.

If traders and investors begin to act on the assumption that the Fed is about to flood the market with bonds without some offsetting stimulative fiscal policies, trouble for stocks is coming.

Higher interest rates choke off investment and slow economic growth. The Fed’s desire to return to normal as quickly as possible is understandable, but runs the risk of creating those conditions while GDP growth is still around 2.5% per year. I am sure that the FOMC is aware of that risk, but seeing stocks at record highs probably feel that some temporary downward pressure on asset prices may be a good thing.

That may be the case for the economy in the long term, but it could send market sharply lower in the short term.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.