Fed commentary on plans for a possibly rapid tightening of monetary policy is likely to be followed by some rather half-hearted action. Indeed, we see the markets forcing the Fed to back off from any aggressive tightening of policy. Financial markets are likely to remain volatile until the US midterm elections in November.
Fed has continued with “verbal tightening” into 2022
The Fed has sharpened its rhetoric considerably in December and January. In particular, the communication, that both “tapering” and a faster reduction in the Fed’s balance sheet might be appropriate, frightened the financial markets. Some think Fed balance sheet reduction might start soon after the first interest rate hike which could come as early as March. Interest rates have risen sharply across the maturity spectrum, the US dollar has appreciated and equity markets, especially the Nasdaq, have weakened. US government bonds have come under more selling pressure than in decades. The 10-year reference US interest rate has risen from 1.37% shortly before Christmas to over 1.8% now.
How serious will the Fed turn out to be when it comes to fighting inflation?
Will the Fed really do what it has announced? This question is likely to be all-important for investors in 2022. We attempt an analysis.
The Chinese central bank (PBoC) has become more expansionary
In contrast to the Fed, the Chinese authorities have started to implement a more expansionary monetary policy to mitigate the impact of the Evergrande default and to stabilize the world’s largest asset class (which is Chinese real estate). The “zero tolerance” strategy towards Covid has already led to new lockdowns in cities with millions of residents, thus increasing risks for the Chinese economy and its troubled real estate sector. Such developments could well create the need for a yet more expansionary monetary policy.
The European Central Bank (ECB) remains significantly more expansionary than the Fed
In contrast to the Fed, the ECB has not so far held out the prospect of further measures in the near term to combat inflation. Interest rate hikes, and in particular a possible reduction in the ECB’s balance sheet, have not yet been seriously discussed.
Fed’s room for maneuver limited by ECB and PBoC
If the ECB maintains its policy of reducing stimulus at a snail’s pace and the PBoC maintains its slightly more expansionary policy, the Fed’s room for maneuver will be limited by a rise in the US dollar.
Democrats are under considerable pressure
The so-called “midterm elections” come up in about ten months’ time. President Biden’s poll numbers are very poor. Many “core” Democrat voters are more interested in low inflation rates and in lower consumer prices, especially lower food and energy prices, than in high stock prices.
Thus, we see a shift in the pressure on the Fed coming from the White House. Whereas the Administration under President Trump explicitly wanted the Fed to inflate asset prices, especially equity prices, the new Biden Administration, facing the high risk of losing majorities (and hence control) in Congress, is now demanding the Fed put more effort into the fight against inflation.
US monetary policy under heavy pressure from Democrats
Until the midterm elections, the political pressure from the Democrats on the Fed to take up the fight against inflation, or at least to suggest that it is serious about this fight, will be strong.
Constraints on the Fed
How can a central bank shift monetary policy quickly in the direction of tightness following years of ultra-inflationary, super-loose policies? And, at a time of record high bond, stock and real estate prices and record high levels of leverage among investors?
Well, it is simply not possible and Democrats as well as the Fed understand this. Therefore, “the soup will not be ladled out quite as hot as it was cooked”.
Thus, the implementation of a tighter monetary policy will turn out to be more gradual and less aggressive than the Fed has suggested in its commentary.
The speed and extent of monetary policy normalization will be limited by the following factors:
Investment consequences: a stronger US dollar and more volatile equity markets
Stock markets, especially US technology stocks which are particularly vulnerable to a rise in interest rates, face difficult times. “Value” stocks, which suffer less from interest rate hikes, could benefit. When selecting stocks, the focus should be on high quality and low debt ratios. The US dollar is likely to appreciate. Investment opportunities in China and Europe, where the central banks look set to stay less restrictive, should be considered.
After the midterm elections…
…there will be fewer political constraints on the Fed, so it will once again be allowed to do what it does best: “create money out of thin air”. Probably, the phrase “at the latest” should be added to the heading above as it is conceivable that financial markets or the state of the economy will have forced a policy reversal before the midterm elections even take place. Assessing the probabilities, we think that an accident will be needed first before the Fed switches back to a policy of “ultra-monetary expansion”.
Contact: Thomas Härter, CIO, Investment Office
Telephone: +41 58 680 60 44
Disclaimer: Produced by Investment Center Aquila Ltd. Information and opinions contained in this document are gathered and derived from sources which we believe to be reliable. However, we can offer no under-taking, representation or guarantee, either expressly or implicitly, as to the reliability, completeness or correctness of these sources and the information pro-vided. All information is provided without any guarantees and without any explicit or tacit warranties. Information and opinions contained in this document are for information purposes only and shall not be construed as an offer, recommendation or solicitation to acquire or dispose of any investment instrument or to engage in any other trans action. Interested investors are strongly advised to consult with their Investment Adviser prior to taking any investment decision on the basis of this document in order to discuss and take into account their investment goals, financial situation, individual needs and constraints, risk profile and other information. We accept no liability for the accuracy, correctness and completeness of the information and opinions provided. To the extent permitted by law, we exclude all liability for direct, indirect or consequential damages, including loss of profit, arising from the published information.
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