Published on August 2, 2022
Much has been made of the market’s relationship with the Fed in recent months, but what has only been mentioned in passing is the impact on market psychology of past Fed actions. When paired with a Fed that is hyperaware of those market psychologies, we find ourselves seeing an interesting dynamic develop today as the Fed battles inflation on one hand and the risk of a recession on the other.
To give context to this discussion, we will paint a simplified picture of the dilemma facing the Fed. Years of loose monetary policy has flooded the economy with cheap capital. Meanwhile, the Fed’s frustration with a lack of legislative resolve led Chairman Jay Powell to leave the free money policy in place during the Covid pandemic. Congress eventually did act, albeit in a more limited capacity than originally intended, but in a way that, when compounded with the Fed’s attempts to offset a prior lack of such fiscal policy, led to an even more aggressive explosion of demand. This, in turn, set the stage for the demand-side impacts exacerbating the current out-of-control inflationary environment.
Of course, inflation at rates not seen in decades is not entirely due to a failure to effectively apply a combination of fiscal policy (which tends to be more precise and surgical) and monetary policy (which tends to be more crude and harder to direct) to manage demand. A collection of supply-side shocks has been as much to blame, including Russia’s invasion of Ukraine and massive supply chain disruptions. Here in the United States, the impact on local supply chains has, in part, been fueled by a shortage of workers needed to efficiently move products from port to storefront.
For this reason and others, the economy is seeing some wage inflation, though not at the rate of price inflation. Demand has continued to stay strong even as labor force participation has stabilized at a rate lower than the pre-pandemic level. But purchasing power continues to erode, as high fuel and food prices take their toll on the average citizen. But the elevated prices of fuel and food are not demand-driven inflationary outcomes; they are driven by lower supply caused by events out of the Fed’s control and (most likely) not significantly impacted by monetary policy.
So as the Fed looks to increase interest rates and wrestle inflation down to its 2% target, Powell must be aware that what he is doing may not bring about the results that the people and markets want to see. No fed funds rate will incentivize Russia to withdraw from Ukraine, for example. On the other hand, he may, for the first time in a few years, be the beneficiary of being in the right place at the right time if such an event were to happen coincidentally. And the Fed can attempt to manage demand with its interest rate policies to limit a compounding effect on inflation. After all, if we are essentially guaranteed to see some inflation from factors out of the Fed’s control, it does seem reasonable for the Fed to try to limit the add-on effect of factors that are within its control.
This brings us to the narrow channel the Fed is trying to sail through right now. By taking an aggressively hawkish stance toward its battle with inflation, Powell risks curtailing demand by shrinking the money supply and reducing lending without a certainty of taming inflation, which could plunge the economy into a recession. The increasing probability of such an outcome has contributed to recent market declines and would no doubt contribute to further declines if this came to pass. Fear of access to capital markets would be resurgent, and the higher risk of corporate defaults would be a long-term cloud over what are already historically dismal markets.
Meanwhile, if the Fed decides to temporarily pause its inflationary focus to address the recession risk, the impact on corporate earnings would be painful. Without help controlling costs, seeing margin pressures continue, companies would be forced to react in one of several ways. Some would probably file for bankruptcy; some would try to raise prices, adding a multiplier effect to inflation; and some would likely lay off employees, which runs counter to the Fed’s other mandate of full employment. Even though the current employment rates are probably even higher than the Fed might target in a healthy economy, no one wants to see people lose their jobs, mandate or not.
Powell got a small reprieve in the July employment numbers, which indicated that the Fed’s higher interest rates have not yet impacted the labor markets. That surely came as a relief given that it preceded another higher-than-expected inflation report just a week later. If the Fed could keep people employed while aiming to lower inflation through higher interest rates, in an environment which saw asset prices decline somewhat but not to the extent that people stopped spending, they would probably be popping open champagne bottles. Powell already has dispatched several of his colleagues to socialize the message that the Fed feels confident in its ability to engineer such a soft landing for the economy. It was notable that the Fed made no mention of recession in its most recent meeting minutes, broadcasting (either intentionally or unintentionally) a lack of concern for this potential outcome.
And so we return to our original observation of market psychology. During the 2008 financial crisis, the market was not sure what to expect from the Fed. The aggressive nature with which the Fed swooped in to rescue not just the economy but the freefall in the markets from the seizure of the financial system was certainly welcome, but the Fed was learning as it went along at that time. The Fed was attempting to use whatever tools it had to avoid a full collapse of the financial system. It took a while for the markets to acknowledge the impact of the Fed’s actions, and it took a while for the Fed to understand what worked, what did not, and why. Once that was processed, such monetary policy actions were called the “Fed put,” meaning investors could count on the Fed to be the markets’ put option (i.e., protection to the downside). Said another way, maintaining functioning capital markets became an unofficial third mandate of the Federal Reserve.
Fast forward to March 2020, and the Fed was able to go back to its playbook. The market again did not know quite what to expect, but market psychology had changed enough that as soon as the Fed acted to support credit markets in ways that mirrored or rhymed with what it did in 2008, it didn’t take investors long to know what that meant. What followed was one of the most violent V-shaped snapbacks we have ever seen, as borrowers and lenders alike recognized that the Fed would do whatever it took to keep credit markets from seizing up to the extent they did in 2008. No one predicted that the result would be credit markets that were even more issuer-friendly than the late 2019 indiscriminate bull market. So much of the late-2020 and early-2021 froth in the capital markets was driven by an oversimplified view that the Fed put would always be there, bolstered by actions that seemed to show that the Fed was embracing its unofficial third mandate.
And why not think this way? Two crises in a row, the Fed supported this point of view. And in between, after the Fed began raising rates from 2015 to 2018, the slightest hiccup in the capital markets caused Powell to do an about face in 2019 which triggered the indiscriminate credit market we mentioned earlier. Market psychology went from not being sure how to react to not being sure what to expect but knowing full well how to react. Where does that leave us now?
Surprisingly, we have heard little about the Fed put in the current environment. It may be that runaway inflation has made the idea of lowering interest rates hard to imagine or more problematic than helpful, but we believe the Fed is well aware of the hold they have on the market psyche. This has given them a new tool in their toolbox that may not have been as impactful as before, and this may enable the Fed to bring the economy in for the soft landing Powell seems to be aiming for, even if the landing strip is both too narrow and too short for anyone’s liking.
The Fed put has become the market’s imaginary friend. Investors no longer need to see it to believe it is there and react to it. This has given the Fed valuable options at its upcoming meetings. Powell can act aggressively to lower inflation by continuing to broadcast additional rate hikes into the future, and still hint at the Fed put if economic conditions appear to weaken. That hint, which might not have previously effected much of a reaction from investors, would likely be enough to avoid a contagion in the capital markets and an overreaction that would undermine the Fed’s employment mandate. Dovish policy is no longer needed; just the threat of dovish policy would likely be enough for the markets to believe the Fed will bail them out when the time comes.
We admit this is a very specific and narrow outcome, and we do not necessarily recommend that investors bet that the Fed will succeed in the soft landing. There is as much risk to the markets that the Fed panics and backs off its aggressive rate hiking stance or that the Fed trundles along with an Alfred E. Neuman-esque complacence about the risk of recession. There are many investors sitting on both sides of this coin, and some will be right and some will be wrong. But there is a chance that this coin flip lands on its edge, and it does not seem prudent to make investment decisions assuming one outcome or another. Now is not the time to sell the markets, nor does it make sense to take indiscriminate risk. Being selective and targeting risk profiles which are designed to perform capably regardless of what happens may serve investors better than trying to predict market direction.
For better or worse, the market’s psychology has changed over the last 15 years. Today’s investors have not just shifted away from a laissez-faire market mentality; they have embraced Fed intervention as not just welcome but as a given, and they will likely react to the mere threat of intervention in the future in a way that we have not seen before. We are unsure what the long-term consequences of this shift will be, but we fully expect the Fed to take advantage of it because it must in order to fulfill what it has itself embraced as an unofficial third mandate to maintain functioning capital markets.
Chief Investment Officer – Sustainable Credit
Venk Reddy is the Chief Investment Officer of Sustainable Credit Strategies at Osterweis Capital Management. Established in 1983, Osterweis Capital Management is an independent asset manager with $7.6 billion under management as of July 31, 2022. The firm provides investment management services to institutions and individuals through mutual funds and separate accounts, offering both equity and fixed income investment strategies.
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The fed funds rate is the rate at which depository institutions (banks) lend their reserve balances to other banks on an overnight basis.
A basis point (bp) is a unit that is equal to 1/100th of 1%.
Coupon is the interest rate stated on a bond when it’s issued. The coupon is typically paid semiannually.