Federal Reserve Policy and Covid
“Securities pricing is, in every sense a psychological phenomenon that arises from the interaction of human beings with fear. Why not greed and fear as the equation is usually stated? Because greed is simply fear of not having enough.” – John Bollinger
Happy New Year! 2021 is in the books and we are now off and running in 2022. Despite the market doing well since the pandemic bottom, the past two years have been full of hardships. For many, it has been mostly tough times sprinkled with some good moments, instead of the other way around. We are going through a pandemic for the first time in 100 years, inflation is back at its highest level since the 1970s, and the current supply-chain issues are the worst we've seen in decades. On top of all of these problems, we now have the Federal Reserve indicating they plan to raise interest rates this year and reduce liquidity. While the broad market is still hovering near all-time highs, every headline seems to read, "Danger, Danger!" In speaking with my clients and observing overall sentiment, there is definitely a lot of fear right now.
Covid continues to be the story that dominates news headlines. It seems to be the never-ending driver of fear in the general public, as well as the financial markets. When the World Health Organization announced a new variant of COVID-19 back in November, the market’s reaction was predictable: A sharp drop, an equally sharp recovery, and then a plateau of watchful waiting. The sharp market moves were due to many investors still having PTSD from 2020, and the prospect of an especially contagious variant spreading like wildfire across the globe once again has investors heading for the hills. Fortunately, Omicron has turned out to have much lower mortality rates and for most people it is no different than the common cold. Even though the new variant is much weaker, that doesn’t mean people are any less afraid. We currently have severe labor shortages as people are staying home from work, as well as government related lockdowns in cities and countries across the world. So, whether it be more restrictions or more cases, Omicron is throwing yet another wrench into the world’s supply chains. This, in turn, keeps prices high and worsens inflation. It also keeps market sentiment much more on the fearful end.
My last several letters, I have written a lot about Federal Reserve policy as it is one of the largest variables in the market and overall economy. Recently, the Federal Reserve released the minutes from its December policy meeting. Wall Street didn’t like what they heard as the Fed indicated they will be more hawkish (inclined to raise rates) than they were at the press conference three weeks prior. Remember, back in March 2020 the Federal Reserve lowered the Federal Funds rate down to almost 0% and expanded the balance sheet from around $4 trillion prior to the pandemic to more than $8.7 trillion now.i Due to these policies, the economy has seen a tremendous rebound since the lows in March of 2020. The pace of growth is well ahead of what the country experienced prior to the coronavirus pandemic. According to U.S. Bureau of Economic Analysis data, we're on track for average growth of around 3.5% per year over the last two years compared with a 2.3% average from 2009 to 2019.ii
Easy-money policies have been a big driver of the rebound. However, they are a crisis tool, and the crisis is over. Removing them doesn't mean the economy is about to crater. It means the economy is healthy. Many argue a withdrawal of stimulus is what is needed. If the Fed were to keep these policies in effect for perpetuity, there would no tools available for the next crisis. The central bank is unlikely to raise rates abruptly overnight and policy tightening will be gradual and drawn out. Unfortunately, this type of policy tightening, or threat of policy tightening, can lead to an increase in stock market volatility.
It should be noted that the Federal Reserve has not actually raised interest rates yet… They are buying fewer bonds than before, but continue buying billions worth of them every month. I remain skeptical the Fed will tighten in a meaningful way this year. The Fed will argue they are a non-partisan independent organization but reality says otherwise. The Federal Reserve Chairman is appointed by the President and the Chairman is routinely interviewed and grilled by Congress. We are in an election year and tightening monetary policy would be bad for many politicians. Something to keep an eye on.
US Treasury Yields
Due to the Omicron Variant and Federal Reserve policies explained above, the market is currently somewhat stagnant and waiting for direction. Not only is there uncertainty in the equity market, but also in the bond market. In 2020, investors flocked to safety in the form of US Treasury Notes and the yield of these bonds decreased. Now that we are moving into more “normal” economic conditions, investors are moving out of Treasuries driving up their yield. The yield on the 10 year is very important and followed for many reasons. In a nutshell, when yields rise, the cost of capital goes up. This increases the discount rate in cash flow models and lowers valuations for many companies. The 10 year is also the rate banks use to price loans. An increasing 10-year treasury yield would slow down the housing market as mortgage rates are based on the 10-year. Currently, the 10-year is yielding around 1.8%. Which is much higher than the 0.4% yield around the Covid bottom when investors were fleeing to safety.
The 10-year Treasury is generally considered to be one of the safest places you can park your money as it is backed up by the full faith and credit of the US government. The yield on the 10-year is 1.8% as mentioned above. However, annual inflation or CPI is currently sitting at 6.8%.iii This means that an investor who parks his or her money in a treasury bill will have negative rate of return of -5%. This unique situation is driving equity returns as investors need to beat inflation. The big winners last year were growth stocks as high inflation made their valuations more reasonable. The graph below shows the 10-year yield on the x-axis and the inflation rate on the y-axis. Inflation is currently running much hotter than the risk-free rate of return. This is a tailwind for equities.
In order to control inflation, the Fed is looking to taper. Again, I question if the Fed will actually taper, but if they do the market may rotate more into value stocks that are lower risk and pay a nice dividend. When/if they taper, large cap dividend paying stocks (blue-chip stocks) could be the big winners in 2022.
Gold and Bitcoin
With uncertainty in Equities and Bonds right now, I figured it would be a good time to revisit Gold and Bitcoin as they usually offer asymmetric non-correlating returns to traditional asset classes. Gold is currently trading around $1,800 an ounce. This is off of it’s high of $2,000 during the covid pandemic flight to safety. Despite ideal conditions, Gold is not very exciting right now, and the under-performance is perplexing to many investors including myself. Gold usually does well during periods of high inflation and low bond yields like we have right now. It is viewed as a currency alternative and one that offers safety when governments are spending more than they take in. While there are many theories as to why gold has underperformed, one is that it is being replaced by cryptocurrencies, primarily Bitcoin. Bitcoin has gained notoriety for massive gains and epic crashes. 2021 was a great year for Bitcoin as the price reached $69,000. Like Gold, Bitcoin does well when the Fed is printing money and fears of inflation are high. With the Fed threatening to taper, Bitcoin has dropped to it’s support zone around $40k. I think both have a place in an investor’s portfolio, with amount determined by individual circumstance.
Markets reward long term investors but positive returns do not happen every year. We need to have realistic expectations and not panic over volatility or a down year. My advice for you is to ignore the headlines. Occupy your time and mind with things you enjoy and try not to worry, that’s our job! In the meantime, my team and I will continue keeping an eye on the markets, using the playbook we’ve worked so hard to assemble. At the end of the day our job is to manage risk and make sure that risk is properly adjusted to reward.
Bruce Carlson, CFP®
Carlson Asset Management