Markets Struggle to Adjust to Fed Pivot

We are three weeks into 2022 and the story so far has been the continued increase in inflation and the impact that is having on the Federal Reserve and interest rates. Last week we got inflation data for December with the release of the Consumer Price Index. From CNBC:

The consumer price index, a metric that measures costs across dozens of items, increased 7%, according to the department’s Bureau of Labor Statistics. The annual move was the fastest increase since June 1982 and comes amid a shortage of goods and workers and on the heels of unprecedented cash flowing through the U.S. economy from Congress and the Federal Reserve.

The continued rise in inflation has finally forced the Federal Reserve to pivot from their easy-money stance to one in which money isn’t free. The first step in this pivot was the elimination of the monthly purchase of $120 billion of treasuries and mortgage-backed bonds. The Fed is currently reducing the amount of bond-buying by $30 billion per month and will be finished with the program by March. The Fed also appears to be ready to begin to raise interest rates beginning in March. The market is now pricing in a 70% chance of four rate hikes in 2022. Just one month ago the odds of four hikes were just 30%. As the market has digested this Fed pivot, the rate on the 10-year Treasury has increased from 1.35% in December to 1.87% today. The final tool the Fed is expected to use will be reducing the size of their nearly $9 trillion balance sheet. The Fed had a hard time doing this step in the decade following the financial crisis of 2008.

This rapid move in rates has led to a decline in stock prices, especially in the tech-heavy Nasdaq which has declined 10% off its recent high. Not only that, 39% of the stocks in the Nasdaq are down over 50% from their highs. The Fed’s easy-money policy clearly was a factor in the froth that occurred in parts of the market in 2021. There have been steep declines in some of these areas from their highs in 2021:

High growth tech: Ark Invest ETF -52%
Crypto: Bitcoin -40%
Clean Energy ETF -47%
IPO ETF -39%
Meme Stocks: Gamestop & AMC -70%

These declines do not mean some of these investments won’t have positive returns in the future, but history has shown when the Fed continues to print money and keep interest rates too low for too long some asset prices reach nosebleed valuations.

In 2021 we believed the Fed was making a policy error by continuing to insist inflation was transitory and thus making no change to their policies. We will see if they follow through their recent tough talk around trying to tame inflation as the year progresses. The good news is the economy is still very strong and certainly should be able to handle the Fed ending the emergency policies they enacted when Covid hit in March of 2020. Also, company earnings are expected to once again be very strong in 2022. We do expect financial markets to see an increase in volatility, similar to 2018, as they digest a more hawkish Fed. We will be here to guide portfolios through this transition as market volatility often produces buying opportunities in quality companies as the baby is thrown out with the bathwater so to speak.