Stock market slide unlikely to make Fed tighten policy

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The Marriner S. Eccles Federal Reserve Building in Washington, DC on Friday, September 17, 2021.

Stephanie Reynolds | Bloomberg | Getty Images

The current stock market slide may spook some investors, but it is seen as unlikely to spook Fed officials away from their current policy trajectory.

In fact, Wall Street is eyeing a Fed that could be tougher this week as it appears to be battling a generational high in inflation amid market volatility.

Goldman Sachs and Bank of America have both said in recent days that they see a growing likelihood that the central bank will be more hawkish, meaning more rate hikes and other measures are more likely to reverse the loosest monetary policy in U.S. history.

That sentiment is spreading and causing investors to reprice stocks that have been hitting record highs but have turned sharply in the other direction in 2022.

“The S&P is down 10%. That’s not enough for the Fed to walk on a fragile backbone. They have to show some credibility on inflation,” said Peter Boockvar, chief investment officer at Bleakley Group. “It would be a bad look for them to bow down to the market so quickly and not do anything inflation-related.”

Over the past two months, the Federal Reserve has made a major adjustment to inflation, which is now at a near 40-year high.

Central bank officials have called the rapid price hikes “temporary” for much of 2021 and pledged to keep short-term borrowing rates near zero until they reach full employment. But with inflation more persistent and aggressive than the Fed has forecast, policymakers have signaled they will start raising interest rates in March and tighten policy elsewhere.

The Fed, which is committed to fighting inflation, is seen as unlikely to step in and stop the bleeding when markets can count on the Fed to ease during previous corrections.

“This goes into the cyclical nature of monetary policy. When asset prices step on the metal, it pushes asset prices up, and when asset prices fall back, asset prices fall,” Boockvar said. “The difference this time is that they have zero interest rates and 7 percent inflation. So they have no choice but to react. At the moment, they are not going to roll over the market.”

The Federal Open Market Committee, which sets rates, meets on Tuesday and Wednesday.

Comparison with 2018

The Fed does have a fairly long history of reversing in the face of market volatility.

More recently, policymakers changed course after a series of rate hikes that peaked in December 2018. Fears of a global economic slowdown in the face of Fed tightening led to the worst Christmas Eve rout in market history that year, followed by multiple rate hikes the following year. Cut interest rates to appease nervous investors.

Besides inflation, there are some differences between this and that market robbery.

DataTrek Research compared December 2018 to January 2022 and found some key differences:

  • As of Friday’s close, the S&P 500 was down 14.8% and is now down 8.3%.
  • The Dow Jones Industrial Average fell from 14.7% to 6.9% now.
  • The CBOE Volatility Index peaked at 36.1 and is now at 28.9.
  • The investment-grade bond spread is 159 basis points (1.59 percentage points), compared to 100 currently.
  • The high-yield spread was 533 bps compared to 310 bps currently.

Nick Colas, co-founder of DataTrek, wrote in his daily report: “With the Fed seeking to assess any measure of capital market stress…we are nowhere near the 2018 central bank rethinking its currency. The timing of the policy stance.”

“In other words: Until we sell riskier assets further, the Fed simply won’t believe that raising rates and shrinking its balance sheet in 2022 is more likely to lead to a recession than a soft landing,” he added.

But Monday’s market action added to choppy waters.

The major indexes were down more than 2 percent by midday, with Nasdaq’s rate-sensitive tech sector down the most, down more than 4 percent.

Market veteran Art Cashin said if the carnage continues, he thinks the Fed may take note of the recent sell-off and move away from a tightening stance.

“The Fed is very nervous about these things. That might give them a reason to slow down a little bit,” Kasin, head of market operations at UBS, said on CNBC’s “Squawk on the Street.” “I don’t think they want to be too public about it. But trust me, I think if it gets worse, if we don’t bottom out and turn things around, they’re going to keep selling into late spring, early summer.”

However, Bank of America strategists and economists said in a joint report on Monday that the Fed was unlikely to budge.

“Every meeting is live”

The bank said it expects Fed Chairman Jerome Powell to signal Wednesday that “every meeting is live,” whether it’s a rate hike or additional tightening. Markets have already priced in at least four rate hikes this year, with Goldman Sachs saying the Fed could raise rates at each meeting starting in March if inflation doesn’t subside.

Although the Fed is unlikely to develop a specific plan, both Bank of America and Goldman Sachs believe the Fed will end its asset purchase program in the next month or two, with the balance sheet starting to shrink across the board around mid-year.

While markets are expecting the full end of the asset purchase tapering in March, Bank of America said it is possible that the quantitative easing program will end in January or February. This in turn could send an important interest rate signal.

“We think this will surprise the market and could herald a more hawkish turnaround than expected,” the bank’s research team said in a note. “The tapering conclusions announced at this meeting will increase our allocation to a 50 basis point hike in March and a possible 50 basis point increase in May.”

Markets have already priced in a 4-25 percent increase this year and were leaning toward 5 percent until Monday lowered those odds.

The report further said that inflation-concerned markets “may continue to bully the Fed into raising interest rates further this year, and we expect Powell’s pushback to be limited.”

Boockvar said the situation is the result of the failure of the Fed’s “flexible average inflation targeting” policy in 2020, which prioritized employment over inflation at a rate similar to that seen during central bank easing in the late 1970s and early 1980s The situation is comparable.

“They can’t print jobs, so they won’t let restaurants hire people,” he said. “So the whole idea that the Fed can somehow affect employment is certainly plausible in the short term. There are a lot of lost lessons here from the 1970s.”


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