The Federal Reserve was so worried about not being hawkish enough that policymakers probably went overboard. The Fed emerged from Wednesday’s meeting with all guns blazing: rapid rate hikes of 75 basis points, faster forward guidance and an unprecedented pace of balance sheet tightening. The avalanche has pushed Treasury yields to their highest level in more than a decade and the U.S. dollar index to a 20-year high, while pushing the S&P 500 near record lows bear market
That’s a lot of stress to put on the financial markets at any time. But today’s global economic base looks particularly fragile as central banks battle inflation; Russia is waging a military war against Ukraine and an economic war against Europe; China struggles amid lockdowns and hangover from housing boom; and governments are saddled with high levels of debt that were further inflated by the pandemic.
Summer rally locked in the Fed
However, the Fed went into last week’s key meeting with one goal: to suppress any possible signs that financial conditions would ease and the S&P 500 would rally.
By all accounts, the Fed had been surprised by the financial market rally that followed its July 27 hike of 75 basis points. From a rally off mid-June lows, the S&P 500 had risen 17% by mid-August. The 10-year Treasury yield had retreated nearly a full point over a six-week period.
Federal Reserve policymakers were outraged by that rally, which seemed to cast doubt on their decision to control inflation. The consequences of thawing financial conditions this summer became all too clear with last week’s CPI report. Too strong a job market still keeps inflation too high. While the headline inflation rate eased to 8.3%, prices for basic services such as rent, healthcare and transport rose 0.6% in the month and 6 .1% from a year ago, the fastest pace since February 1991.
Correction of messages from the Federal Reserve
The summer rally began to unravel on August 26, when Fed Chairman Jerome Powell, in a speech from Jackson Hole, Wyo., abandoned his earlier optimism that the North America could avoid the recession. Instead, Powell noted that the Fed will keep policy tighter for longer, shoring up the economy so the current burst of inflation doesn’t turn into a 1970s-style chronic disaster.
Powell’s speech kicked off a market reassessment of the Fed’s policy outlook, undoing the dovish impression he gave at his July 27 news conference that had helped the S&P 500 pare its 24-day loss % to more than half, coming out of a bear market.
August’s warm CPI reading pushed the market’s interest rate expectations even higher. As it turns out, the Fed’s policy signals on Wednesday mostly just confirmed the bad news that Wall Street was already expecting. A third consecutive rate hike of 75 basis points came at a full price. Markets already had slightly above 50% odds that the key federal funds rate would rise to a range of 4.25%-4.5% by the end of 2022 and come. 4.5%-4.75% in 2023.
There is no Fed for the S&P 500, or for the global economy
So why the sharp market decline since Wednesday’s Fed meeting? The tenor of the meeting ensured that investors will not doubt the Fed’s decision again. Markets now expect another 75 basis point increase on November 2 and another half point move in December. That comes as the Fed has doubled the pace of its balance sheet tightening to $95 billion a month, nearly double the $50 billion monthly rate that helped trigger a market meltdown and a nearly bear for the S&P 500 at the end of 2018.
At the time, inflation was too low, not too high, so Federal Reserve policy turned on a dime. Policymakers shelved their plan for a series of rate hikes to guard against the possibility of higher inflation. The balance sheet adjustment slowed and then stopped. By the fall of 2019, the Fed had begun cutting rates and buying more assets. This time, there is little hope for a Fed hold-up until markets turn much uglier.
The bigger problem may be that the tightening isn’t happening in a vacuum, but is creating ripples in interconnected financial markets around the world. As Treasury yields rose after the Federal Reserve meeting, so did the US dollar against foreign currencies. This prompted Japan to step in to prop up the yen for the first time since 1998. Other currencies, including the euro and the British pound, are also breaking past key long-term support levels against the dollar.
When the Fed’s need to tighten to meet its domestic inflation mandate creates problems for the rest of the world, markets can quickly disengage, as they did in early 2016 and late 2018. In both cases, the Fed quickly backed away from aggressive tightening plans. . This time will be different.
The World Central Bank
The Fed is sometimes considered the world’s central bank, in part because the dollar is the world’s reserve currency and key commodities, such as oil, are priced in dollars.
While the dollar’s strength will help control inflation in the US by lowering the price of imports, it will deepen problems for other countries struggling with inflation. Several foreign central banks followed the Fed’s big hike on Wednesday with their own bigger-than-expected hikes on Thursday. But raising interest rates and weakening their economies could worsen debt sustainability problems and put pressure on currencies.
On March 2, just after Russia’s invasion of Ukraine, Powell told Congress he would support a quarter-point rate hike at the next meeting, not half a point. “We will use our tools to increase financial stability,” Powell said. “We will avoid adding uncertainty to what is already an extraordinarily challenging and uncertain time.”
It’s not clear that the Federal Reserve struck the right balance this week.
S&P 500 on a knife’s edge
A soft September jobs report on October 7 and a less problematic CPI reading a week later could provide some respite for markets. But next week could be a wild ride.
After falling 9.2% over the past two weeks, the S&P 500 is now down 23% from its all-time closing high on Jan. 3 and just 0.7% off its closing low of Jan. 16 june The Nasdaq composite is also approaching June lows, while the Dow Jones hit a 22-month low on Friday.
Be sure to read IBD’s The Big Picture column after each trading day for the latest on the current stock market trend and what it means for your trading decisions.
Please continue @IBD_JGraham on Twitter for coverage of economic policy and financial markets.
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