Fed Day – The beginning of the end…

By David Nelson, CFA CMT

As strategists, portfolio managers, analysts, or market pundits we tend to hype the importance of events to support a narrative that explains our market outlook. In the last decade it has been hard to write a market piece or research report without some mention of the Federal Reserve and or a perceived timeline of FOMC actions.

This Wednesday’s FOMC decision and press conference that follows is one of the more consequential in recent memory. Hints of a tapering of bond purchases have been with us for months. The only real surprise would be the absence of confirmation from Fed Chair Powell that they were locked and loaded ready to kick the taper into gear sometime later this year. With the Fed currently purchasing about $120 Billion a month in fixed instruments, Wall Street can’t seem to agree on the pace of a coming taper. Will it be a reduction of $10 or $15 Billion per meeting and will it be calendar based or a discretionary timeline decided by the committee’s view of current economic conditions. 

Fed Balance Sheet

Data by FactSet

We can debate the details of FOMC actions but what isn’t up for debate is the outsized influence they have on financial markets; asset returns and the unintended consequences of those decisions. Post the financial crisis monetary policy and specific actions by the FOMC have helped propel U.S. markets 573%. Ready to pump any measure of liquidity needed the FOMC provided an implied backstop for investors, what  is commonly known as the Fed Put. The original TARP or Troubled Asset Relief Program proposed by then Fed Chairman Ben Bernanke is barely visible as part of the today’s $8.4 Trillion Fed balance sheet.

S&P 500 Financial Crisis – Today

Data by FactSet

There’s a reason why we parse every line of an FOMC press release. Most valuation models start with the risk-free rate. In world where that data point is effectively zero valuations get blown out encouraging risk taking. When the cost of risk goes down, speculation and the accidents that follow go up.

The Cost of Risk

Definition: The ICE BofA Option-Adjusted Spreads (OASs) are the calculated spreads between a computed OAS index of all bonds in a given rating category and a spot Treasury curve.

It’s pretty clear from the chart above issued by the St. Louis Fed that the cost of risk has been plummeting. Not the lowest in the last 20 years but certainly pushes the edge of the envelope.

Investors turn cautious

Since the last non-farm payroll report earlier this month markets have taken a decidedly cautious tone. Traders have only put together just 2 days in the green culminating in Friday’s quadruple witching options expiration. The S&P 500 closed below the 50-day moving average for the first time since June an event notable enough that Barron’s dedicated an entire article to its importance. What is important for investors isn’t the breach but the days that follow and whether we start living below the average.

Data by FactSet

With inflation running hot including headline standouts like Natural Gas more than doubling this year one would think the Fed is under pressure to act sooner than later. The weak jobs report along with estimate revisions to the upside starting to slow drives investor concern that the Fed will be forced to reduce accommodation just when the economy is running low on fuel. Post August’s payroll numbers several firms including Goldman, Morgan Stanley and Bank of America cut GDP estimates followed by several strategists cutting their market targets for the year.

The beginning of the end or the end of the beginning – After a ferocious recovery off a pandemic low, fueled by the promise and then delivery of an effective vaccine, the end of the first stage of recovery has come and gone. A lot of demand has been pulled forward and now with the increased challenges of inventory depletion and delta variant that has sparked both a political and health debate, the economic pause is well understood.

Markets are looking for a catalyst good or bad. With earning’s season still a month away, Wednesday’s FOMC decision takes on added importance. Beyond that the House and Senate are wrestling over a $3.5 Trillion package, the debt ceiling, immigration and a list of challenges that goes well beyond what I have patience for. Like it or not the market’s next cue comes from Washington.