Can the Fed tame inflation without further crushing the stock market? What investors need to know.
The Federal Reserve isn’t trying to slam the stock market as it rapidly raises interest rates in its bid to slow inflation still running red hot — but investors need to be prepared for more pain and volatility because policy makers aren’t going to be cowed by a deepening selloff, investors and strategists said.
“I don’t think they’re necessarily trying to drive inflation down by destroying stock prices or bond prices, but it is having that effect.” said Tim Courtney, chief investment officer at Exencial Wealth Advisors, in an interview.
U.S. stocks fell sharply in the past week after hopes for a pronounced cooling in inflation were dashed by a hotter-than-expected August inflation reading. The data cemented expectations among fed-funds futures traders for a rate hike of at least 75 basis points when the Fed concludes its policy meeting on Sept. 21, with some traders and analysts looking for an increase of 100 basis points, or a full percentage point.
The Dow Jones Industrial Average DJIA,
See: Stock-market bears seen keeping upper hand as S&P 500 drops below 3,900
A profit warning from global shipping giant and economic bellwether FedEx Corp. FDX,
Read: Why FedEx’s stock plunge is so bad for the whole stock market
Treasurys also fell, with yield on the 2-year Treasury note TMUBMUSD02Y,
Investors are operating in an environment where the central bank’s need to rein in stubborn inflation is widely seen having eliminated the notion of a figurative “Fed put” on the stock market.
The concept of a Fed put has been around since at least the October 1987 stock-market crash prompted the Alan Greenspan-led central bank to lower interest rates. An actual put option is a financial derivative that gives the holder the right but not the obligation to sell the underlying asset at a set level, known as the strike price, serving as an insurance policy against a market decline.
Some economists and analysts have even suggested the Fed should welcome or even aim for market losses, which could serve to tighten financial conditions as investors scale back spending.
Related: Do higher stock prices make it harder for the Fed to fight inflation? The short answer is ‘yes’
William Dudley, the former president of the New York Fed, argued earlier this year that the central bank won’t get a handle on inflation that’s running near a 40-year high unless they make investors suffer. “It’s hard to know how much the Federal Reserve will need to do to get inflation under control,” wrote Dudley in a Bloomberg column in April. “But one thing is certain: to be effective, it’ll have to inflict more losses on stock and bond investors than it has so far.”
Some market participants aren’t convinced. Aoifinn Devitt, chief investment officer at Moneta, said the Fed likely sees stock-market volatility as a byproduct of its efforts to tighten monetary policy, not an objective.
“They recognize that stocks can be collateral damage in a tightening cycle,” but that doesn’t mean that stocks “have to collapse,” Devitt said.
The Fed, however, is prepared to tolerate seeing markets decline and the economy slow and even tip into recession as it focuses on taming inflation, she said.
The Federal Reserve held the fed funds target rate at a range of 0% to 0.25% between 2008 and 2015, as it dealt with the financial crisis and its aftermath. The Fed also cut rates to near zero again in March 2020 in response to the COVID-19 pandemic. With a rock-bottom interest rate, the Dow DJIA,
Investors got used to “the tailwind for over a decade with falling interest rates” while looking for the Fed to step in with its “put” should the going get rocky, said Courtney at Exencial Wealth Advisors.
“I think (now) the Fed message is ‘you’re not gonna get this tailwind anymore’,” Courtney told MarketWatch on Thursday. “I think markets can grow, but they’re gonna have to grow on their own because the markets are like a greenhouse where the temperatures have to be kept at a certain level all day and all night, and I think that’s the message that markets can and should grow on their own without the greenhouse effect.”
Meanwhile, the Fed’s aggressive stance means investors should be prepared for what may be a “few more daily stabs downward” that could eventually prove to be a “final big flush,” said Liz Young, head of investment strategy at SoFi, in a Thursday note.
“This may sound odd, but if that happens swiftly, meaning within the next couple months, that actually becomes the bull case in my view,” she said. “It could be a quick and painful drop, resulting in a renewed move higher later in the year that’s more durable, as inflation falls more notably.”
