In 1955 the Fed Chair William McChesney Martin famously defined his role thusly: “The Federal Reserve…is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.” One would have to expect that a man once described as a “the happy Puritan” was a stern chaperone, discouraging frivolity on his watch. Compared to Mr. Martin, Chair Powell is the wacky dad doing keg stands at his son’s high school graduation party.[i]
Yesterday’s FOMC meeting indicated that the Fed would slow down its refilling of the punchbowl as early as November and that it is likely to take it away entirely as soon as next year. I am of course referring to the tapering and rate hike comments that the Chair offered yesterday during his press conference. He indicated that tapering was likely to begin “soon”, which is often Fed-speak for “next meeting”; that it would likely end by mid-year, and that rate hikes could begin late next year.
This sounds pretty dire for a liquidity-driven (or liquidity-intoxicated) market, right? If so, then you haven’t been paying close enough attention to market psychology over the past year or more. We noted yesterday that SPX closed lower 10 of last 12 times in the 3 day period that included and followed an FOMC meeting. This was during a raging bull market when 62% of all 3-day periods were higher. On those occasions, despite overwhelmingly market-friendly moves from the Fed, investors didn’t seem to like what they heard from Chair Powell’s press conferences. It is likely that investors had discounted ragingly bullish comments from the Fed, only to have them delivered in Chair Powell’s measured tones. Why then wouldn’t the opposite be true when he calmly delivered bad news that was to some extent expected by investors?
There is some evidence that investors were already bracing for the worst. Many market participants had been taking note that reverse repo activity had been picking up at the New York Fed. We noted this as early as May. This is a way for the Fed to drain excess liquidity from markets – a necessary activity when excess liquidity threatened to push short-term rates into negative territory. The Fed has been guaranteeing 5 basis points on reverse repos, and have been greeted with over $1.2 trillion in daily overnight reverse repos. The Fed knows that it has been overfilling the punch bowl, yet is willing to wait another 6 weeks or so to give investors time to adjust.
Remember that unlike many prior meetings, markets were coming into the FOMC announcement after a down streak. Monday’s selloff was attributed to worries about contagion resulting from the potential default of China Evergrande. At the time we were somewhat dismissive about the prospects for contagion because US high yield bonds barely reacted. If Evergrande was the catalyst for a global credit crisis it would have affected the weakest US credits, and it did not. We instead attributed it to a confluence of technicals and timing. The S&P 500 Index (SPX) broke the 50 day moving average that had supported it for months, and it occurred on the Monday before a Fed meeting and after a quarterly expiration. We looked for a test of the 100 day moving average, and when the test proved successful the “buy-the-dip” crowd returned in earnest after licking some initial wounds. It has behooved investors to stay fully invested (“Everlong”) and to add to positions on pullbacks. We may have entered an environment when the threshold for dip buying has increased, but the rationale remains in place for now.
If the Federal Reserve has been providing the punch for the party, Congress has been the ones periodically spiking it with grain alcohol (Everclear). Monetary stimulus has kept the market party going, and fiscal stimulus made it all the more exciting. We know that many of the stimulus payments found their way into stock and cryptocurrency markets, amplifying the already potent expansion of the Fed’s balance sheet. Yet Congress is finding that the liquor store now won’t even accept their ID. The infrastructure, budget reconciliation, and debt ceiling bills are all imperiled. Investors are not willing to panic about the prospect of a government shutdown – they’ve been burnt doing so before, as Congress proved unwilling to stomach its full consequences – but it is clear that the prospect for future fiscal accommodation is at best uncertain. Yet the party continues.
Could it be that investors know that the party is winding down and simply don’t care? We’ve all been in situations like that, where we’ve been having so much fun that we don’t want to get our coats yet. The Fed has only indicated when the bar might close – last call might be a ways off. It could be quite some time until we find out whether there will be enough cabs to take everyone home safely when everyone realizes that the party ended. In the meantime, it might make sense to at least call a car service and consider whether to try to beat the rush.
[i] This is something one of my sons witnessed at a friend’s high-school graduation party. Not by his own dad, mind you.
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