The era of stimulus is over

Former Fed chair Janet Yellen famously said that central bank policy should be like ‘watching paint dry: uneventful, unsurprising and dull. She didn’t get her wish in 2017, when she expressed it ahead of the Federal Reserve’s last attempt to put US monetary policy back on a path to normal. And her successor Jerome Powell would also be disappointed were he to repeat the hope today as he kicks off the latest round of monetary policy tightening. Whatever the Fed does this year, it won’t be boring.

There weren’t many actual fireworks this New Year for obvious reasons. But we didn’t have long to wait for pyrotechnics in the financial markets. The publication last week of the minutes of the US central bank’s pre-Christmas meeting ensured that the year got off to an explosive start as the Fed removed any doubt that the era of ultra-stimulus is over. Markets were shocked but they should hardly have been. 

With inflation standing at a 40-year high, it is clearly absurd for the Fed to be engaged in emergency support measures for an economy that’s within a whisker of full employment.

The December minutes, and Mr Powell’s confirmation hearing this week, confirmed that the Fed will be implementing a three-pronged assault on spiralling prices this year. The first two legs we already knew about. 

1. The central bank will rapidly reduce to zero the amount of government bonds and mortgage-backed securities it buys each month. It has been spending US$120 billion a month doing that since early in the pandemic, but it will stop completely by the spring. 
2. It will start raising interest rates, with at least three rate hikes this year, maybe four, and the same again next year. 

What investors didn’t expect, but should have, was the fact that the Fed’s policymakers have also started to discuss a third measure: not simply refraining from adding to its now swollen balance sheet but actually reducing its size.

Is the Fed feeling brave?

There are two ways it can do this. It can stop replacing the bonds it owns when they mature, or at least a proportion of them. If it is feeling really brave, it can also start to sell some of the nearly US$9 trillion of bonds on its books before they are due to be repaid. Either way, it will increase the volume of bonds that someone else will have to buy as it steps back from being America’s investor of last resort. 

All other things being equal, those investors, at home and abroad, will demand a higher yield to compensate them for helping out. Yields will rise. Which is another way of saying that the value of bonds, and other assets priced with reference to them, will fall.

The market response to this new regime has been fast and furious. The yield on the 10-year Treasury bond, the bedrock of the world’s financial markets, rose almost immediately from 1.5% at the end of last year to 1.8%. That is still low by historic standards but, in the normally sedate government bond market, that’s a dramatic re-adjustment. The repercussions in the stock market were eye-catching too. The NASDAQ index, chock full of the kinds of high-growth shares which have thrived in an environment of rock-bottom interest rates, lost 4% in the first five trading days of the year. Since its peak in November, it has fallen by more than 10%, the usual definition of a market correction.

If the Fed delivers on its proposed tightening, it will mark a sea-change in the investing environment. As the relative performance of growth and value-focused shares in recent days suggests, it could rekindle the rotation away from the technology shares that have kept the market on its upward trajectory throughout the COVID period and towards the more cyclical companies that will benefit most from an inflationary boom as we come out the other side of the pandemic. 

Given the importance of those high-growth tech stocks to the US market - five shares represent nearly a quarter of the value of the S&P 500 - the bigger concern is that the other 495 will not be able to rise fast enough to make good the shortfall. Their ability to do so may be determined by how quickly last year’s earnings recovery moderates into a more sustainable growth rate. The results season that starts tomorrow with a handful of big US banks’ earnings announcements will be key.

So, once again, investors must hope that the Fed is more concerned about stability in the financial markets than in preserving its own credibility. Ever since the US central bank stepped in to support the economy and markets in the wake of the financial crisis, it has consistently stepped back from the brink when push came to shove. The last time it tried to get policy back to normal between 2017 and 2019, it waited two years from its first interest rate hike before trying to reduce the size of its then US$4.5 trillion balance sheet. Even so, it was forced to abandon the attempt after getting rid of just US$600 million worth of bonds.

During the pandemic, it has doubled the size of its balance sheet again and to make a serious dent in its holdings today it is going to have to drop a load more bonds on the market than it was able to three years ago. Investors are betting that it will lose its nerve again this time, but they may be wrong to do so. The difference today is inflation, which has not been this high since the Fed was battling to overcome the crippling price spirals of the 1970s. The market’s fear has always been that if inflation were allowed to spin out of control, the cure might be worse than the disease. This is the year when we will find out.

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