What the Federal Reserve is doing does not at first glance seem terribly extreme.
As of this writing, 3-month Treasury bills, one-year Treasury notes, and 10-year Treasuries yield 2.43%, 2.71% and 3.04% respectively. Those are not bad numbers. However, the problem is that one must look at these numbers in context. They must be viewed in the context of ten years of very expansive Fed policy. The market has been on a sugar high for ten years. So if you suddenly take away the sugar, what do you think is going to happen? Bad things.
What should concern people is that even a relatively modest reversal by the Fed from the policy of recent years is causing such a great disruption in the financial markets and the economy.
The markets have become dependent on Federal Reserve policy. That is not a healthy economic environment.
At the beginning of 2018, the markets did not seem to be troubled by rate increases. Inflation was beginning to reassert itself. And investors understood that it was time to unwind the Fed stimulus. Investors did not seem concerned until the Fed said that there will be several additional rate hikes. In September investors became alarmed when the Fed signaled that they would raise rates several more times.
“Our economy is strong,” Powell said at a press conference on Wednesday. “These rates remain low. My colleagues and I believe that this gradual returning to normal is helping to sustain this strong economy.”
The central bankers raised expectations for a fourth rate hike in December. And a majority now in favor of such a move. Furthermore, in June, policymakers were split on whether the Fed should raise rates four times this year or three.
Looking ahead to 2019, Fed officials expect at least three rate hikes will be necessary. In addition, they are projecting and one more in 2020.
As a result, within a month following that Fed decision the markets began to stumble.
“The Fed is looking to undo the perception that they are the ones that are driving economic growth.” This according to Michael Yoshikami, CEO and founder of Destination Wealth Management. “They’re going to not only raise interest rates, but they’re also going to begin to unwind what they think is an overdependence by the market on Fed policy.”
Now observers are beginning to sound alarms. As early as last April, some expressed a warning about changes in Fed policy.
Over the longer term, the real policy risk facing Wall Street may not come from the White House or Congress, but from the Federal Reserve.
The U.S. central bank has been gradually shifting its monetary policy in two significant ways: raising interest rates and reducing the size of its balance sheet. Low rates and the Fed’s bond-buying program are seen as major contributors to the equity market’s massive rally over the past decade, and while changes to these policies have been widely telegraphed, analysts say Wall Street is still not appreciating the risk they represent.
“Years of accumulated policy distortion, a lack of Fed maneuvering room and shock waves from policy are the S&P 500 risks we see, but not corporate earnings or economic growth,” said Barry Bannister, head of institutional equity strategy at Stifel. Bannister has been warning about Fed-related risks for a while, and he recently speculated that if the Fed mishandles the transition to a more normalized policy, that could spark an “unusually rapid” bear market, leading to a “lost decade for stocks,” or 10 years with no positive returns.
Furthermore, recent reports indicate that the economy has started on a downward projection. No one is sure how severe a slowdown might be.
In its annual assessment of global prospects the Bank predicts continued, though somewhat slower, growth this year and next. The Bank’s forecast for the global economy is expansion this year of 2.9% and 2.8% in 2020. But overhanging the broadly favourable outlook are rising concerns that could mean economic performance falls short.
Volatility on Wall Street has led shares across the globe on a wild ride in recent months. As a result a number of stock markets are dipping into bear territory. That’s set to worsen in the new year. Bear markets — typically defined as 20 percent or more off a recent peak — are threatening investors worldwide. In the U.S., the Nasdaq Composite recently entered a bear market. In addition, the S&P 500 entered one on Monday. Globally, Germany’s DAX, China’s Shanghai Composite and Japan’s Nikkei have also entered bear market levels.