By Tom Burnett CFA
As the U.S. stock markets grind upwards slowly after the recovery from the March 2020 lows, investors have become more sensitive to inflation and interest rates. Rising rates could halt the rise in the equity markets as investors devote more resources to alternative investments that offer higher income distributions. The Fed has certainly gone all out to stave off the negative economic impact of the Covid-19 outbreak and the measures installed to halt its spread. In late-May, the Federal Reserve Bank of New York released an 82-page report summarizing the “Open Market Operations of 2020” which disclosed important projections of future Fed activities. The Report suggests that the Fed’s balance sheet could grow to over $9 trillion by the end of 2022, up from $4.3 trillion in March 2020. The balance sheet is now $7.9 trillion according to the latest Fed press release. The current balance sheet total is now 34% of nominal GDP, the highest percentage since 2014. By the middle of next year, the figure could be 39% of GDP. The Report from the NY Fed Bank assumes that current policies will be extended well into 2022 when the asset purchase programs will be wound down.
Investors know that the Fed is currently purchasing $120 billion a month-$80 billion of Treasuries and $40 billion of agency mortgage securities as one of its most prominent tools for managing liquidity and easing the economic pressures following the Covid-19 pandemic. This program plus the pledge to maintain short term interest rates at the range of 0-0.25% are the two main tools the Fed is using to keep the economy growing and to move the unemployment rate down from post-Covid high levels. Most observers expect the Fed to maintain its policy on short-term rates at least until next year, but the focus on the asset-purchase timetable is generating conflicting views. When the Fed finally announces that it has begun to ‘taper’ its asset purchases, the markets may sell off sharply. The last Fed Open Market Committee report was issued on April 28, 2021, and the next scheduled meeting and press release are set for June 15-16. Some observers expect the Fed to slow its asset purchase program this year as liquidity and fiscal policies have dramatically improved the current economic picture. The Fed will at some point decide that the asset purchase program is no longer necessary and may lead to inflationary pressures which will need to be contained in 2022.
Investors forget to watch the Fed at their peril. For example, the last time the Fed consciously tightened its policies was in 2018 when the market, as measured by the Dow Jones Average, fell 3.6% after two good years in 2016 and 2017. The Fed corrected its negative course in early 2019 and the stock market rose by more than 25% that year. Seasoned investors learned long ago not to ‘fight the Fed’ but close observation of Fed policies is required to make sure the interpretation of those policies is correct.
Tom Burnett CFA is Director of Research