The Resonant Review: A Soft Landing in a Lightning Storm?
February 4th, 2022
The classic 1986 film "Back to the Future" ends dramatically with Doc Brown struggling to balance the Old Clocktower in the middle of a thunderstorm in order to save Marty McFly's future. The doctor has to precisely time a lightning strike - a risky proposition - to help convert the DeLorean and its flux capacitor into a time machine that will take Michael J. Fox's Marty back to the present day. Spoiler alert: things work out perfectly for our heroes.
During January’s market volatility, we couldn’t help but think that the Federal Reserve is in a similarly-risky circumstance as it attempts to engineer a soft economic landing while investors struggle to hang on during a challenging environment. The prospect of interest rate increases and the Fed simultaneously reducing both its bond-buying and also its historically-large $8.9 trillion balance sheet caused material market disruption to open the year. To extend the movie metaphor, investors are clearly uncertain as to whether, in economic policy terms, the Central Bank can time the tight-rope walk with a lightning strike.
The Fed was clearly behind the curve in recognizing the true state of the economy. Add in easing risks from Omicron, a tight labor market and elevated inflation statistics and the Fed had to quickly re-evaluate its policy and narrative during the first month of the year without losing credibility or spooking the markets. Their communications became increasingly hawkish and the timeline for the first interest rate increase was pulled forward to March of 2022.
Stock market participants responded, and major equity indices fell during the month. The S&P 500 declined -5.2% while the technology-heavy Nasdaq fared even worse, posting a decline of -9.0%. Fixed income markets have also begun to price in Fed policy changes. Fed Funds Futures are currently pricing in a 100% chance of a March rate hike. The yield on the 2-year Treasury increased 50%, moving from 0.78% to 1.18%. The move in the 10-Year Treasury was not as pronounced, increasing from 1.63% to 1.79%. The difference between these two yields, referred to as the “10-2 spread,” has historically been a useful leading indicator of potential recessionary activity. As economic expectations improve, the spread between the two widen; as expectations worsen, the spread narrows. The spread has now flattened to a new 52-week low. Will the Fed crush the economy in its attempt to tamp inflation down? Considering the Fed’s expected rate hikes, we would argue against a significant decline in economic activity over the near term based upon current labor market conditions, consumer balance sheets, housing activity and pent-up consumer demand. The Fed is likely to be able to hang onto the clock tower despite the inclement weather, at least for 2022.
Unfortunately, to reduce inflation, raising interest rates is only part of what the Fed must get right. The Fed must also determine how best to normalize its balance sheet. Questions remain over how exactly quantitative tightening or the reversal of the Fed’s pandemic-bloated balance sheet will work. It is this “timing of the lightning strike” that is much trickier and also happens to be historically-unprecedented. Kind of like…time travel in a jerry-rigged, out-of-production automobile. No wonder markets reacted so violently to the Fed’s hard policy reversal in January.
When he realized the enormity of the task he was confronted with, Doc Brown famously exclaimed “Great Scott!” Fed Chair Powell has clearly had his own such moment and admitted as much recently when he said: “The balance sheet is still a relatively new thing for the markets and for us, so we are less certain about that.”
The tug of war between the Fed’s efforts to normalize policy against a backdrop of moderate-to-strong economic activity will continue to weigh on the markets this year and as such we wouldn’t be surprised to see continued market volatility. We have written about many of these issues over the past year(s), though it is cold comfort to have been proven correct in our predictions. And unfortunately, the Fed and Treasury have created an economic situation that has significant unknowns, and thus potential risks, in the future.
The sequel to Back to the Future opens with Doc Brown’s return to see Marty and his girlfriend, Elizabeth Shue’s Jennifer. Doc hurriedly explains that they need to go Back to the Future (again). Marty asks “Why? Does something happen to us?” Doc’s reply is apropos to current and future market and policy circumstances, as he says “No, not you Marty. It’s your kids! Something has got to be done about your kids!” Authorities have provided an incredible amount of monetary and fiscal intervention for a domestic and global economy that has proven remarkably resilient. The basic principle of every action having an equal and opposite reaction has us concerned about the unknowns and unintended consequences of their present behavior on future economic and market outcomes. We are, in effect, thinking about “the kids” and working to position portfolios to effectively protect and provide them with opportunity for the world they will live in. We aim to be as effective, if less theatrical, as Doc Brown.
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