CIO Flash: The Fed takes off its mask

“It is more likely than not that last week’s communication by the Chair of the Federal Reserve, Jerome Powell, was a policy mistake,” writes Chief Investment Officer Yves Bonzon in his last market update of 2018. What are the implications for the financial markets? And how should investors position themselves?

A week ago, in what we believed would be our last CIO Flash in 2018, we emphasised how important the Federal Reserve (Fed) communication about its balance sheet reduction programme was. The Federal Open Market Committee (FOMC) communique did not allude to it at all and we had to wait for the Q&A of the post FOMC press conference for Mr Powell to provide clarity on the topic. And that he did in no uncertain terms. We quote:

‘If you go back some years, people working at the Fed in 2013/2014 took away the lesson that the market could be very sensitive to news about the size of the balance sheet and we came to the view that we would have the balance sheet run off on automatic pilot and use monetary policy, rate policy, to adjust to incoming data. I don’t see us changing that.’

‘We will continue to use rate policy as the active tool of monetary policy.’

Dismissing the balance sheet as a policy tool goes way beyond regular monetary policy normalization.

When the Fed, at the time still under the leadership of Mrs Yellen, announced Quantitative Tightening (QT), we commented that the prudent path would be to not shrink the size of the balance sheet given the lack of historical and empirical evidence about the impact of such a policy move on asset prices. We understood the decision as politically motivated to insure Fed independence. Up until October of this year, evidence pointed to a successful, smooth and orderly balance sheet reduction process.

The market action of the last two months points to a completely opposite conclusion. No one knows for sure what the right course of action for the Fed is, not even Mr Powell. Dismissing the balance sheet as a policy tool and keeping it on auto pilot goes way above and beyond regular monetary policy normalization. Only a belief that the world is back to the post war economic paradigm would justify such a move.

The latest decline has already erased about 5 trillions worth of wealth.

As you know, we believe that advanced economies have become more sensitive to asset prices than interest rates. According to some estimates, as much as 25% of US consumption is directly linked to changes in US households wealth. Pre-crisis, the US market capitalization was USD 20 trillions. It crashed to below 10 trillions in the spring of 2009 and subsequently recovered to above USD 30 trillions. The latest decline has already erased about 5 trillions worth of wealth. As a point of comparison, the US housing crisis between 2006 and 2009 inflicted a negative wealth shock of roughly 7 trillions. We can only repeat our view that further declines in asset values from here on will mechanically trigger a US recession. The tail is wagging the dog!

It is more likely than not that last week’s communication by Mr Powell was a policy mistake. Removing a tool from the FOMC toolbox is not only unnecessary but dangerous. This goes way beyond monetary policy normalisation. In our view, this actually puts normalisation at risk of complete failure if markets tank, forcing the central bank back into Quantitative Easing (QE) at a later stage.

Recommended course of action for portfolios
Let’s look at the facts. Every FOMC meeting this decade was positively sanctioned by investors and the S&P 500 went up. Since Mr Powell took office, every FOMC meeting has triggered a market decline. The regime change is very clear.
As we are nearing the end of the trading year, books are closing. Investors sentiment, which is the most bearish it has been since the first quarter 2016, may be low for longer and the market is deeply oversold. Therefore, we recommend the following:

  • Let’s wait a little to see how the market digests the new reality at the Fed. If the Fed has indeed triggered a bear market, we still see 2200 on the S&P 500 as the worst case scenario and we will most likely not get there without a violent bear market rally before that.
  • Concentrate portfolios on quality bonds and quality equities rather than bombed out junk assets.
  • Do not take any major currency bets, particularly in emerging markets.

We would like to close the year with a constructive message. We cannot ignore the potential implications of what was disclosed by Mr Powell last week. We think he might have planted the seed of destruction of his normalisation objective.

Nonetheless, we remain open to alternatives, mindful that we might be wrong. In any case, while our portfolios suffer some mark to market losses in the short run, we are invested in high quality assets whose fundamental value has not changed. Going forward, the expected return of our portfolios has gone up significantly and this is what we should concentrate on.

Many thanks for your trust.

Very best wishes and a happy New Year 2019!

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