If we could pass on a bit of wisdom to our readers about the market today, it would be “Don’t fight the Fed.“
Unbeknownst to many investors, the old saying, don’t fight the Fed, is a two-way street. It is easy for investors to understand the advice when the Federal Reserve provides liquidity. During these periods of easy monetary policy, markets tend to rise daily. Volatility is low, meaningful dips are rare, and pullbacks tend to be superficial.
But when the Fed raises interest rates and reduces liquidity, it is wise to realize that the trend is often not investor-friendly. In this scenario, not fighting the Fed is a warning to take a more conservative stance.
Given the Fed’s current tight monetary policy agenda and its impact on asset prices, we thought it might be useful to share our thoughts on the Fed-based trend analysis.
The trend of the Fed is your friend
The Federal Reserve provides liquidity to the markets directly and indirectly.
By buying or selling bonds, they affect the amount of investable dollars available to the markets. They also provide liquidity directly to investors via repo markets. Both measures directly affect the amount of money and securities in the financial markets and, accordingly, all prices of financial assets.
Equally important is the indirect effect of the Federal Reserve on liquidity. The perception that the Fed is supporting the markets or not is a strong one. Investors usually feel more confident knowing that the Fed is adding liquidity, no matter how much liquidity finds its way into the markets. On the contrary, as we see now, anxiety tends to arise when they remove liquidity.
“Monetary policy is 98% talk. – Ben Bernanke
Raising and lowering interest rates is another way that indirectly affects liquidity. Higher rates increase the cost of utilizing financial assets and vice versa for lower rates. The so-called margin trading increases the purchasing power of buyers.
Due to the direct and indirect effects of the Federal Reserve, stocks often trend higher when the Fed is going down and down when liquidity is removed.
By understanding how the Fed affects the markets, we need to consider the degree of ‘influence’ they provide.
Critics of the financial media often rate the Fed and its members on a pessimistic and pessimistic scale. A tight plan is one in which Fed members want tighter monetary policy to slow economic growth and/or inflation. A pessimistic attitude means an easier policy to support or enhance growth and/or prices.
The table below from InTouch Capital Markets is one example. It is necessary to bear in mind that the degree of strictness or dovishness is relative. For example, Neel Kashkari is the most pessimistic member of the Federal Reserve today. Despite his cautious views, he is aggressively calling for a series of price hikes and QT.
“Right now, it’s easy to be a hawk because inflation is out of control and the labor market is strong.” – Neil Kashkari
Cutting interest rates once or twice by 0.25% is very different from abruptly cutting them to zero percent and starting a blanket purchase program of quantitative easing as we saw in 2020. The more the Fed changes monetary policy, the greater the market impact. More importantly, the more severe the resulting market price trends.
cliffs falcon doves
Price trends tend to be the sharpest, up or down when monetary policy is at its most extreme. Today, monetary policy is likely to be tighter than at any time in the past 30 years. The chart below provides hypothetical examples of changing price trends based on Fed policy. The current environment is closer to the strong yellow streak than the Hawkish. The strong pacific orange line represents the last two years of very easy monetary policy.
Trend slope analysis shifts with Fed forecast. For example, nine months ago, the upward trend began to stabilize. At the time, inflation was rising rapidly, and the Federal Reserve started talking about raising interest rates. Since the initial expectations were for slight hikes in interest rates and a lack of QT, the trend has been flat and the eventual turn to the downside is gradual. Since then, the downward trend has only increased, with the Fed’s comments becoming increasingly hawkish.
The slope of the trend will shift with monetary policy expectations. Inflation, economic growth and employment are driving those expectations. If inflation starts to fade quickly and economic growth continues to weaken, we think the Fed’s tone will be less hawkish. In such a scenario, the downward slope of the trend will become less steep.
At some point, the market will assume that the Fed has tightened enough. Whether it’s a recession or much lower inflation, expectations of a change in policy stance will become more and more common. Then the consolidation period becomes likely. Expectations on quantitative easing and lower interest rates are likely to follow, and the uptrend may resume.
Standard & Poor’s 500 2020-2022
Unfortunately, the concept of trend analysis we are discussing is just an abstraction. While the Fed-based trend analysis is useful, it is impossible to quantify the Fed’s caution and toughness on trend slopes. However, understanding slope and direction can be a powerful risk management tool.
The chart below shows the changing trend channels of the S&P 500 over the past two years.
There are a few things worth noting in the graph.
- Between zero interest rates and unprecedented levels of quantitative easing, the Fed used very easy monetary policy from March 2020 through early 2022. As such, the upward trend was sharp. The S&P 500 is up more than 100% in less than 2 years!
- The upside is well defined, with support at the 100-day moving average (green) and resistance at 7.5% above the 100-day moving average (green dotted). Any breaks above or below the channel were opportunities to trade and rebalance.
- From September 2020 to June 2021, the S&P 500 will closely follow the upper green channel resistance.
- Around June 2021, investors began discussing the possibility of a shift to the Fed’s less pessimistic stance. From that point on, the S&P 500 started trading below the resistance level and occasionally touching support. The slope of the trend was fading. We can see this as the trend intensity has started to decline (grey shaded area).
- With inflation rising beyond expectations and bullish rhetoric becoming more common, the S&P index started to consolidate (black channel).
- A new downtrend channel started in 2022 (in red). As we can see, the channel support has begun to establish itself.
The Fed is unlikely to get any more hawkish than it is today. The question is, when will they start to switch to a less hawkish policy. At that time, the slope of the red channel is likely to be flattened, and the bottoming process can begin.
The Fed has just begun its tightening campaign. Prices rose on three occasions by a total of 150 basis points. Fed fund futures include another 2% increase in interest rates by the end of 2022.
The current stock trend is sharply sloping downwards. It will likely stay that way until the market believes the Fed has given up. Sometimes prices veer towards the bottom of the channel and other times they veer towards the top. Trading within the channel can be a valuable trading tool in a bear market.
The Fed and short stocks don’t fight when the Fed provides liquidity. Equally important and relevant today, the Fed does not fight back by aggressively buying stocks when the Fed withdraws liquidity from the markets.