Why the Fed's next policy move really matters

The Federal Open Market Committee’s next two meetings are scheduled for 2-3 May and 13-14 June and the monetary policy decisions which come out of them could go a long way to setting the tone for a wide range of asset classes for the rest of this year and beyond.

After three glacially-paced interest rate increases the minutes of the Federal Reserve’s last monetary policy meeting, which took place in March, revealed the US central bank had begun to actively consider shrinking its balance sheet and reverse the $3 trillion-plus expansion that has resulted from its Quantitative Easing (QE) stimulus programme.

Whether this was instead of, or in accompaniment to, further interest rate increases was not clear. Nor is any tightening of any kind guaranteed, but the implications of the so-called sterilisation of QE are potentially far-reaching.

Bulls will argue any such move by the Fed to slim its balance sheet and neutralise the nearly nine-year old monetary stimulus programme is the ultimate sign of the bond-buying scheme’s success – namely that the US economy is back on track 10 years after the first signs of sub-prime mortgage distress became clear, and is finally capable of functioning without emergency support.

Yet sceptics will assert that this is the ultimate test of not just the US economy but America’s stock market. Even bulls of the S&P 500 used to regularly parade the chart below, which maps the size of the Fed’s balance sheet against the headline US index, although it has become less prevalent since the Yellen-led Fed started to reduce the size of QE in December 2013 and stopped adding to it altogether in October 2014.

It can be argued that QE has boosted US stock prices …

Source: FRED, St. Louis Federal Reserve database; Thomson Reuters Datastream

Up, up and away

Since the launch of the QE bond-buying scheme in autumn 2008 under Ben Bernanke the assets on the US Federal Reserve’s balance sheet have swelled from $900 billion to $4.5 trillion.

This prompted doubters to argue the US economy and its stock market were being supported by the Fed’s newly-created money and efforts to drive bond yields (and thus borrowing costs) to unsustainably low levels, creating unforeseen side effects, such as huge increased levels of borrowing by consumers and corporations, companies buying back shares with cheap debt to goose their reported earnings figures and a bull run in stocks which at times appeared to rely more on cheap money than it did on corporate profits and cash flows.

The next chart shows the year-on-year change in the size of the Fed’s balance sheet against the year-on-year change in the S&P 500, a perspective which at least lends some credence to the view that cheap money has gone a long way to driving US stocks to new highs – although recent market action does suggest the index is doing its best to break the apparent link, inspired by the Trumpflation/reflation trade:

… so it is possible that any sterilisation of QE could have the opposite effect

Source: FRED, St. Louis Federal Reserve database; Thomson Reuters Datastream

No certainties

The FOMC minutes offer no promises of sterilisation and stress that any move to withdraw this stimulus would be made gradually, mirroring the baby steps made under Janet Yellen to tighten monetary policy via three interest rate increases so far (since December 2015) and the decision to stop adding to QE in 2014.

The minutes even contained the following gem, which suggested Yellen and her fellow monetary policy voters were leaving every option open:

“A number of participants indicated that the Committee should resume asset purchases only if substantially adverse economic circumstances warranted greater monetary policy accommodation than could be provided by lowering the federal funds rate to the effective lower bound.”

The Fed therefore discussed circumstances under which QE could be extended and expanded, not just sterilised.

For the record, the market expects the Fed to leave interest rates unchanged in the 0.75% to 1.00% target range on 3 May, while potentially laying the groundwork for a second increase of the year (and fourth of this upcycle) at the June or July meetings.

This table shows what potential policy path is being priced in by US interest rate futures markets:

Markets do not expect the Fed to move at the May FOMC meeting

Source: CME Fedwatch

As a result, the battle lines are now drawn between bulls, looking foward to a healed US economy and one fired up by the proposed Trump reform programme, and bears pointing toward historically very high valuations on a market-cap-to-GDP and cyclically-adjusted price earnings (CAPE or Shiller PE) basis, moderate corporate profit momentum and the withdrawal of QE as key obstacles toward fresh advances in US stocks.

For those advisers who are in the bullish camp, the good news is there is a wide range of actively- and passively-run funds from which to choose as a means of gaining exposure, in exchange for a fee:

Best performing US Large Cap Blend Equity OEICs over the last five years

(Where more than one class of fund features only the best performer is listed.)
Source: Morningstar, for US Large Cap Blend Equity category

Best performing North American Investment Trusts over the last five years

* Includes performance fee
Source: Morningstar and the AIC, for North America and North American Smaller Companies Categories.

Best performing US Large-Cap Blend Equity ETFs over the past five years

(Where more than one class of fund features only the best performer is listed.)
Source: Morningstar, for US Large-Cap Blend Equity category.

Precious metal poser

But it is not just advisers and clients with exposure to US stocks who will be closely watching the Fed’s every move.

All of this also matters to those who have cash in UK equities, because in stock market terms the UK tends to follow where America goes, at least if history is any guide.

Where American stocks go, British ones tend to follow

Source: Thomson Reuters Datastream

Besides tracking the CME Fedwatch website, and its daily monitoring of what interest rate futures markets expect, advisers and clients can also use the gold price as a potential guide to what the markets expect from the Fed.

As this final graphic shows, the precious metal’s price surged when then Federal Reserve chairman Ben S. Bernanke launched America’s QE scheme in late 2008 and rocketed as QE-I gave way to second and third phases of the monetary experiment.

Gold has since struggled to make headway as Bernanke’s successor, Janet Yellen, first lessened the monthly amount of QE and then finally cut it to zero, bringing the increases in the Fed’s balance sheet to a halt. Interest rate hikes have kept a further lid on gold, despite its decent run this year.

Any sense that the Fed is going to back away from further increases in the headline cost of borrowing (or leave QE alone or even extend QE if the US economy takes an unexpected turn for the worse) could give a fresh boost to gold. In contrast, any hint of growing confidence in the economy and further monetary policy rigour could dampen demand for the haven metal.

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.

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