Before we get started — we’ll be off next week for Labor Day. Have a great weekend, and we’ll see you on the 9th!
Don’t fight the Fed.
It’s a classic Wall Street saying alluding to the Federal Reserve’s control over the market. If you’re trying to trade against the people that ultimately pull the interest rate levers, you’ll probably end up losing.
Why? Because in a nutshell, interest rates dictate the way you and I spend, save, borrow, and invest.
These days, though, it’s almost trendy to fight the Fed. We’ve all made our jokes about “transitory” inflation and the money printer. And up until last week, the riskiest investments led the market higher, even during the steepest rate hike campaign in decades.
Is the Fed about to fight back?
Turning the ship
Throughout history, the Fed has existed at odds with investors. The Fed tends to swoop in when conditions feel the worst, adjusting policy and cutting rates to cushion the economy against a Great Depression-like outcome that breaks the financial system.
The opposite is true, too. If things feel too easy, the economy can develop some unsustainable habits like high inflation and excessive speculation. Then, the Fed comes in and starts hiking rates to keep the economy running at a healthy, Goldilocks-ish pace. Rate hikes aren’t necessarily a bad omen for the market — in fact, stocks tend to rise in rate hike cycles — but the Fed naturally works against the tide, turning a ship that’s heading in a treacherous direction.
Today, the Fed is turning the ship, but there’s a lot of work still to be done. Inflation may be slowing, but it’s still too high for the Fed’s liking. You wouldn’t be able to tell that from the market’s reaction, though. Since the July meeting, tech stocks and speculative names have led the market higher — two groups that tend to thrive more in low-rate, low-inflation environments. Over the past month, financial conditions have loosened the most since November 2020. The Fed told us to flip to the next chapter, yet we’re jumping to the end of the book.
Cognitive dissonance
There’s a reason why many of us are fighting the Fed, though. We’re not looking for a brawl, we just don’t know what the Fed’s intentions are at the moment.
Sure, the Fed wants to fix inflation, but Powell has acknowledged that rate hikes are weighing on growth. Then, we see awful data from a rate-sensitive sector like the housing market: Existing home sales are sliding 20% year-over-year, and mortgage apps are falling to the lowest level in two decades. You can’t help but think higher rates play a part in that. This week, we were thrown off guard by a surging US dollar, showing that global capital is overwhelmingly seeing the US economy as a safe haven in a struggling global economy.
Fed officials insist the inflation job isn’t done yet, but the data shows it could be, if we let the cracks in the economy keep spreading. The US economy is simultaneously suffering from slowing growth and high inflation, yet it seems to be the cleanest shirt in the global economy’s dirty laundry pile. That’s a lot of cognitive dissonance for a market that’s been relatively cut and dry over the past decade.
To be fair, the Fed hasn’t helped clear things up. Before the Great Financial Crisis, the Fed rarely communicated its rate hike plans to the market. In fact, the Fed’s post-meeting press conferences — the ones that get tens of thousands of views on YouTube — have only existed since 2011. The Fed just changed policy and let investors deal with it. Tough love, but at least the message was clear.
Since then, the Fed has gotten louder with press conferences and public comments, using its megaphone to inform markets about its thought process on policy. Transparency has a lot of benefits, but right now, the Fed’s megaphone is confusing a lot of people. Powell has talked about several outcomes for policy over the coming months to convey he’s willing to be flexible, but people are taking his comments as a sign that rate cuts are coming soon.
Maybe they are, but it’s often more complicated than that. The Fed could keep hiking at a slower pace or pause at a high policy rate. Both options may be a gentler approach than what we have now, but they could still hamper the economy’s growth potential. Long pauses have been more common at the end of recent rate hike cycles — almost like the Fed needs to see danger before it cuts rates unnecessarily.
Either way, if the market leans too far into this rate cut theory, it may be in for reality checks like the ones we’ve seen lately — quick, painful selloffs in growth stocks and crypto.
Picking a side
The Fed is sending mixed messages, and everybody’s picking a side instead of thinking through how this news could manifest itself in a portfolio. In a way, the Fed is trudging through the dark as well — that’s why it’s trusting the data more.
Luckily, you don’t have to pick a side or predict the future. Being prepared for all scenarios — hikes, a pause, or a cut — may be a better way to manage this uncertainty. Your best approach as an investor in this environment is to determine the right balance of growth and safety in your own portfolio. It can be costly to miss the early days of a new bull market, but it can also be costly to fight the Fed and over-extend yourself. While we may not test the lows of this selloff again, we also may not reach new highs any time soon.
*Data sourced through Bloomberg. Can be made available upon request.