July 19, 2021
The fed giveth, and the fed taketh away
Around the globe, COVID-19 killed millions of people, caused nearly 100 million to lose their job, and decreased economic output by several trillion dollars. When times get this bad, we investors are prepared to see losses in our portfolios.
But in 2020 we saw the opposite. The S&P 500 was up 18%, almost double its 90- year average, and this year it’s up another 13%. What gives? There are several factors, but the biggest is probably the Federal Reserve (The government’s $6.8 trillion of stimulus is a close second).
What’s been done: Of the many actions taken by the Federal Reserve, the two most impactful have been the lowering of the Federal Funds Rate and the expansion of its balance sheet (quantitative easing or QE).
At the onset of the Coronavirus, the Federal Reserve lowered the Federal Funds Rate from 1.5% to 0%. Nearly all short-term and intermediate-term interest rates are affected by the Federal Funds Rate. Lowering this rate reduced the cost of borrowing on mortgage and home equity loans, auto loans, and other borrowing which spurs economic activity.
The Federal Reserve has always had a balance sheet, but it hasn’t been until recently that it was used to prop up asset prices in times of economic turmoil. The Fed’s balance sheet was about $900 billion prior to the 2008 Financial Crisis. It quickly increased to $2.2 trillion at the end of 2008 and then gradually expanded to $4.5 trillion in 2014. The pandemic roughly doubled the Fed’s balance sheet from $4 trillion to $8 trillion, where it stands today. The explicit purpose of the Fed’s bond purchases is to keep long-term interest rates low to spur long-term lending. A consequence is that it raises all asset prices from bonds to stocks to homes. The cheaper things can be financed, or the lower the discount rate of future cash flows, the higher the price is today.
Where things stand now: The Federal Funds Rate is close to 0% and isn’t expected to increase until 2023. The Federal Reserve is continuing with its quantitative easing program, buying $80 billion of treasury bonds and $40 billion of mortgage-backed bonds each month. Annualized, these $120 billions of monthly purchases work out to nearly $1.5 trillion per year. The Federal Open Market Committee has yet to make an official statement on the future of this program, but Chairman Powell has said a change in asset purchases will come before a change in the Fed Funds Rate, leading some to speculate it could happen by the end of 2021.
Many believe the Fed must trim back their accommodative policy or we’ll see significant inflation in the coming years.
What the future may hold: If recent history is repeated, the Federal Reserve’s unwinding of their accommodative policy will not be good for markets in the short term.
In 2013, the Federal Reserve was buying $85 billion a month in Treasury bonds and mortgage-backed securities. On June 19th, 2013, Ben Bernanke announced the Fed would stop (or “taper”) their asset purchases by the following summer. Both the stock and bond market had a “taper-tantrum,” with global stocks dropping 6% in the ensuing week and the aggregate bond market dropping 2%.
In 2018, the Federal Reserve began selling off its assets, reducing its balance sheet from $4.4 billion to $4 billion and increasing the Federal Funds Rate from 1.25% to 2.25%. This substantial reversal of accommodative policy corresponded with poor performance from the stock and bond market. Global equities declined 10% in 2018 and the aggregate bond market finished the year flat after briefly being down 3% at times during the year.
What investors should do: Understand that the incredible stock and bond returns over the last decade are unlikely to continue.
What investors should not do: Sell in and out of the market in anticipation of the Federal Reserve’s policy changes. Final thoughts: Federal Reserve tightening seems to have been harmful to markets in the past, but before being too clever for your own good remember:
1. No one knows for sure when the changes will happen.
2. Just because markets went down in the past doesn’t mean they will in the future. With all the factors affecting stocks and bonds, no one thing ever acts in isolation.
3. Expected returns from stocks and bonds are still positive, cash remains a poor investment.
4. Rising interest rates are harmful to short-term asset prices but mean greater expected returns in the future.
Over the short term, there will always be reasons to fret capital markets. However, if people keep working, business gets done, and wealth keeps being created, investors will reap rewards over the next 100 years just like they have over the last 100.