The start of the year has seen markets trade on their backfoot, with traders already throwing in the towel and begging the Fed to intervene to support a market that is down 10% year to date. The fact that the market is up 25% since before COVID started and is up a solid 80% from the March 2020 lows seems to evade them altogether.
Since the COVID-induced shutdown in 2020, global central banks have thrown copious amounts of money into the markets, with the Federal Reserve bloating its balance sheet from $4 trillion to close to $9 trillion as of this past week. There was a time during the Lehman crisis when the Fed would embark upon a $120 billion quantitative easing (QE) program, but during COVID it was buying that much per day!
There is no doubt the aggressive monetary policy along with rate cuts helped take the equity markets back to pre-COVID levels and beyond with all this extra money sloshing around. But we have reached a point where COVID is being declared an endemic as opposed to pandemic and economies have reopened more or less, yet the Federal Reserve still is buying $60 billion to $90 billion per month and plans to do so all the way through the end of March.
When the Fed embarked on its "let's-save-the-market" crusade in 2020, it had a dual mandate of getting employment back to pre-COVID levels and maintaining inflation at an average of 2%. Nearly two years post the pandemic's start, we have inflation now averaging about 7% year over year in December. After stating that inflation would be transitory for the better part of last year, the Fed has no choice but to alter its views.
What is baffling is that the Fed thought inflation was not possible. It perhaps can be forgiven for its naïve thinking as inflation was never a problem during its Modern Monetary Theory exercise over the past decade. This time we saw not only a combination of monetary but also fiscal policy; inflation was inevitable. The heightened inflation level is not only due to a secular change in supply chain shortages, but it also is seen in almost every part of the economy where raw material prices for goods and services are all being increased by their respective companies. Inflation is here to stay for some time. The level may not be 7%, but it is surely not 2%.
One of the biggest drivers of the equity market and risk assets over the past decade has been the Fed-induced liquidity that entered the market every time there was an economic or financial wobble. The minute the Fed tried to remove that liquidity the market fell apart.
We saw that in 2018 and then in 2019 repo crisis when the Fed justified QE to fix a "technical plumbing" problem. The fact is that this debt bubble has gotten too big and the only path the Fed can take is to print even more money each time the markets has needed it. Hence the market is one big addict, constantly waiting for its next fix.
This was the mood set for the Federal Open Market Committee meeting this week, especially as the markets are weak, especially with risk-levered assets down 50 to 70% from the highs. But this time, something has changed. The Fed has its hands tied, for even if the economy is running out of juice it cannot print more. If it does, inflation will surely spiral out of control, causing another kind of collapse. The Fed's only choice is to raise rates, and we know it cannot do that too aggressively.
As Fed Chairman Jerome Powell presided over the FOMC meeting, the markets cheered initially as they did not see any change to policy, only to give away as Powell during his post-meeting news conference reiterated that inflation is higher than December and that the Fed would be open to seeing rates rise in March.
Basically, the Fed did not give in to the market's tantrum earlier this week and has maintained its pledge to end the QE by March and then "act accordingly if need be." The Fed plays a backward-looking role; it only reacts to events as opposed to pre-empts them. The Fed
should have started normalizing its balance sheet last year after economies were rejoicing and bouncing off the lows. Instead, it now must think about raising rates as the economy is pleating, showing signs of hurting.
The market is pricing in about four rate hikes for this year alone; whether the Fed is able to do that is another matter. For now, the data will be monitored as if inflation does not ease.
The Fed may have no choice but to wean the market further off of its opioids. But can the markets survive on their own without this liquidity? I think we know the answer to that one.