What would make the Federal Reserve change tack?

Regular readers could be forgiven for thinking that this column is obsessed with the issue of liquidity, not least because that is the case. We have already looked at how central banks are draining it away (28 Sep ’18) and how issues such as capital controls could mean that advisers and clients must never assume that it will always be easy to buy or sell assets, owned directly or indirectly via funds, when, in the size and at the price they want (26 Oct’ 18).

This week, we must return to the issue of central bank policy because our warning that higher rates and less Quantitative Easing (QE) could at least provoke increased volatility does not seem too far off the mark, in the wake of the autumn stock market wobble. Consider this: at the time of writing, the Fed has now reduced its balance sheet by some $351 billion, or 8%, while the S&P 500 is some 7% off its all-time high.

This may be just a coincidence but it is enough to prompt complaints from no less than President Trump, whose willingness to measure his administration’s success by how high the US stock market goes may yet prove a poor choice of yardstick.

The Fed’s move to shrink its balance sheet and reduce monetary stimulus may be weighing on US stocks

Source: FRED – St. Louis Federal Reserve database, Refinitiv data

The President’s colourful accusations that his country’s central bankers are ‘loco’ and ‘going crazy’ articulate a deep-rooted fear in the markets that higher rates and less stimulus could mean lower share prices. The Fed does not seem moved by such talk as yet, but this does beg the question of what might have to happen for the US central bank to stop tightening and start loosening policy once more.

Different script

Fed chairman Jay Powell’s predecessors Ben Bernanke and Janet Yellen oversaw the launch of all three phases of the Fed’s QE scheme in November 2008, November 2010 and September 2012. All three of those programmes came in the wake of a combination of

  • stock market weakness
  • a sell-off in high yield (junk) bonds (as benchmarked by the US-quoted iShares iBoxx High Yield Corporate Bond Exchange-Traded Fund, which has the ticker HYG)
  • A flattening in the yield curve (a decline in the premium yield offered by US 10-year Treasuries relative to two-year ones)

Yet Powell seems to have a different outlook, given his 2017 quote that “it’s not the Fed’s job to stop people losing money” and the US central bank’s recent suggestions that the yield curve is not as reliable an indicator as it once was (see this column 21 Sept’ 18).

If financial market indicators will not sway Mr Powell and colleagues, then perhaps we have to look to real-world, economic ones.

Three indicators

This column has therefore trawled through a substantial batch of US data to see which items may have influenced Fed thinking under Mr Bernanke and Ms Yellen. Of the real-world ones, three in particular seem to have tempted the US central bank to pull the monetary stimulus trigger in the past (the rings show when QE1, QE2 and QE3 were launched):

  • Weakness in the Institute for Supply Management’s (ISM) manufacturing purchasing managers’ index (PMI)
  • Weakness in the non-farm payroll data and a loss of momentum in job creation
  • A slackening in the rate of inflation

The three following charts hopefully provide some illustration of this, with the rings highlighting when each phase of QE came into effect.

Marked softness in manufacturers’ confidence could persuade the Fed to stop tightening (or even ease) policy …

Source: FRED – St. Louis Federal Reserve database, Refinitiv data

… As could a slowdown in job creation …

Source: FRED – St. Louis Federal Reserve database, Refinitiv data

… And a marked deceleration in the rate of inflation

Source: FRED – St. Louis Federal Reserve database, Refinitiv data

On our own

This makes sense, since the Fed has a twin mandate of employment and inflation.

Inflation has ebbed a little and the PMI has pulled back slightly from its peak but neither really has done so to the degree seen ahead of QE2 or QE3. Moreover, US job creation is still strong, judging by the 250,000 new non-farm payrolls added in October and 3.1% wage growth.

Under such circumstances, the Fed seems unlikely to be deflected off course by increased asset price volatility. Financial markets are on their own.

It is now for advisers and clients to decide whether momentum in earnings, cash flows and dividends are sufficient to justify prevailing valuations and compensate them for the specific risks that come with individual asset classes and geographic regions, because there is no longer enough cheap money around to lift all prices on a tide of liquidity.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.