Investors held their collective breath as they waited on Jerome Powell to announce the newest Fed action the week before Christmas. Central bankers were unanimous in their decision to move to a less accommodative stance, and the market reaction was swift and fierce. The date, December 19th, 2018, when the Fed lifted the Fed funds rate from 2.25% to 2.5%. You might be forgiven if you thought I was talking about December 15th, 2021, when they were once again unanimous in recommending that their pace of bond-buying should slow more rapidly as they target three rate increases in 2022. The question remains, how will the market react this time?
You may recall, as we entered December 2018, the United States was in a contentious state with China as the Trump administration fought for tariffs on Chinese goods. Talk of a recession was on the table, and many thought the Fed should leave rates alone. However, they raised them anyway, and the S&P accelerated its drop from its all-time high by 20% (a bear market) in just two months as we approached Christmas. A late rally that included a 1,000-point daily gain in the Dow the day after the holiday undid much of the damage, but all US indices finished the month down 8.7% or more, the worst December return since 1931. The Fed promptly reversed this decision the following month, and we have not seen rates at that level since.
In December 2021, we are affected the most by a virus that originated in China. While growth is strong, inflation is impacting the world more than at any time in recent memory. Central bank bond purchasing, a 0% Fed funds rate, a tight labor market, higher gasoline costs, and supply chain issues contribute to this phenomenon. Jerome Powell announced that they will begin buying “only” $60 billion in bonds starting in January 2022, down from $120 billion just a couple of months prior in November. The market will soon decide if this is a prudent course. I hope that the previous so-called mistake in 2018 did not make the central bankers hesitate too long. We could see a repeat of the Carter years which required aggressively higher interest rates to stem inflation.
Comparison of the two periods:
|Unemployment Rate (Nov.)||3.80%||4.20%|
|GDP Rate (annualized)||5.47%||5.97%|
|Oil Price (Nov)||$62.32||$79.92|
|National Debt (billions)||$21,516||$28,400|
|Federal Deficit (billions)||$779||$2,772|
|Fed Balance Sheet (billions)||$4,075||$8,664|
While we cannot predict the future, we can make some educated guesses about the impact on the economy. Interest rates should rise. Fed purchases of US government debt and corporate bonds drove interest rates to historically low levels. This financed a boom in housing prices and spurred many companies to continue their stock buybacks while borrowing cheaply. New projects will need to meet a higher hurdle rate to be profitable, impacting GDP growth. Our national debt could start growing even more rapidly as more money is dedicated to financing interest costs. Much of this money is loaned to us by our own Federal Reserve who sends the interest payments back to the Treasury. This will slow when/if they pare their balance sheet.
Despite being many years past the 2008 market crash, interest rates never returned to their historical averages. The COVID pandemic forced an even lower rate reaching an all-time low in August 2020. European rates went negative over the same period as borrowing became “almost free” in some countries. My guess is that investors will not take kindly to higher rates, but perhaps they will keep spending money anyway. After all, it is the holiday season.
If you are concerned about the market or looking to diversify your exposure in this uncertain environment, please contact me. I would be happy to assist.
Greg Taunt – firstname.lastname@example.org