The stock market is ignoring one of its traditional mantra’s to ‘not fight the Fed’. This phrase was coined by investor Marty Zweig in 1970 in his book, Winning on Wall Street.
The Fed is trying to reduce inflation
The Federal Reserve has raised interest rates in hopes of bringing down inflation. However, recently there has been a loosening in financial conditions – stocks have gone up and government bond yields have fallen – which is the opposite of what the Fed is trying to accomplish by aggressively hiking interest rates.
The Chicago Fed national financial conditions index is now back in ‘loose’ territory at levels last seen back in April before the Federal Reserve raised interest rates by 200bps. The recent rally has essentially undone much of the Fed’s efforts to try and slow the economy.
Why the Fed raised interest rates
One of the goals of the Federal Reserve is to keep inflation at its target rate of 2%. Over the past six months, inflation has reached highs unseen in decades. To try and reduce inflation, the Federal Reserve stepped in and raised interest rates. When interest rates go up, borrowing money becomes more costly, and for those that do borrow, more money is expended paying higher interest rates. Higher interest rates also encourage people to save money and postpone loans, which means that there is less money in circulation and therefore less economic activity. Once this happens, inflation goes down.
The Fed will fight the market
Federal Reserve governors have protested this loosening calling it ‘too much, too soon’. This sets the stage for some market volatility in the future to be generated from the Federal Reserve and/or economic data.
The Federal Reserve governors have two primary means of affecting the market in the near future. The first is at the Jackson Hole symposium this week, when its statements can affect the market. The second is at the September 21st FOMC (Federal Open Market Committee) meeting where it decides whether to hike interest rates by an additional 0.5% or even 0.75%. Key economic data including the August jobs report (on September 2nd) and August CPI data (on September 13th) may impact how the FOMC decides to act.
The recent rally has propelled the highest risk assets the most, from disruptive tech onwards. These assets are most vulnerable to a healthy breather in the rebound, or a worse-case pullback. The higher the rally goes now, the greater the risks of aggressive Fed action or resulting economic data which could drive down the market. Nonetheless, the longer-term recovery remains supported by peaked inflation, resilient earnings and consumers, and a still depressed overall investor sentiment.