INVESTED: In Markets, in the Future, and in Society.

The notion that the Federal Reserve (Fed) stands ready to inject liquidity into markets (i.e., lowering interest rates or quantitative easing) when stocks struggle is known by investors as the “Fed put”. From an economic standpoint, when the stock market experiences severe drawdowns, this can lead to a decline in economic activity, which then has implications for the labour market and consumer prices. While the Fed doesn’t have a formal policy to support the stock market, the interconnectedness of the economy makes it such that the central bank pays attention to what is going on in financial markets, especially as it relates to the plumbing of the market (liquidity).

One could argue the Fed is more concerned about the proper functioning of the fixed income market given that large corporations need to access short-term funding for their operations; if this gums up and cracks begin to emerge, there is usually a spill-over into the broader stock market. The notion of a “Fed put” as a balancing feedback loop makes sense in normal economic conditions, but in 2022 with inflation running at the fastest clip since the 1980s, the Fed’s put may have gone kaput. Investors that have been conditioned to “buy the dip”, assuming liquidity from the Fed will arrive in a swift fashion to help bolster risk appetite, may need to rethink this strategy in the context of the inflationary environment as the Fed aims to rein in consumer prices. 

Adding fuel to the slow burn that has been financial markets in 2022 is the fact that the selloff has been relatively calm. The VIX (a gauge of stock market volatility) has risen this year, but is still below 30, and is a far cry from the 80-handle witnessed during the heart of the COVID-19 panic. High-yield spreads in the US are creeping higher, but at this point, look more like a normalization than the market sniffing out an imminent recession. Financial markets are now in uncharted territory. As this article from the Man Institute shows, this is the first time in history (since data became available), that both stocks and bonds have fallen together for five weeks in a row. 

Furthermore, slumping productivity growth in the US creates a challenging path forward for the Fed and financial markets as it relates to monetary policy. The Fed is being forced to walk a tightrope between keeping monetary policy conditions loose enough to hopefully spark productivity, while not letting prices continue to spiral out of control. While there is a low probability the Fed comes to the rescue while inflation remains high, this is an environment where commodities are likely to continue their outperformance. Even in the scenario where the Fed is too aggressive in its tightening and hikes the economy into a recession, supply-side issues may still outweigh the destruction in demand that comes from a Fed-induced recession.