Will Federal Reserve Raising Rate Cause a Stock Market Crash?

Will Federal Reserve Raising Rate Cause a Stock Market Crash?

The Federal Reserve is stuck between a rock and a hard place. Will their raising the rate cause Stock Market Crash?

Inflation Shoots up Placing Greater Pressure on the Federal Reserve

Last week the latest US CPI (Consumer Price Index: a weighted average market basket of consumer goods and services purchased by households) inflation numbers for February 2022 came in at 7.9% which was higher than most expectations.

This marked the highest inflation numbers in the last 40 years. For most of the pandemic, high ranking Fed (Federal Reserve) officials including chair Jerome Powell made it a point to stress that in spite of all the liquidity/money injected into the financial system and put in the hands of individual citizens, inflation will be “transitory” and that it will eventually “wane away”.

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Federal Reserve’s Challenge: Money Supply is off the Charts

The M2 broad money supply which was rising ~6.1% YoY (year over year basis) post the 2008 GFC (Global Financial Crisis) went “parabolic” during the initial months of the pandemic. In absence of the pandemic, M2 money supply as of December 2021 would likely have been ~$17.25T, but today it stands at a staggering $21.6T (i.e., ~25% higher than it would have been as per historical growth rate).

Federal Reserve: Confusion adds to Stock Uncertainty

The Federal Reserve for the longest time possible had a 2% inflation target but they were unable to trigger anywhere close to 2% inflation in several years preceding 2020. Now inflation is at a level last seen during the late 1970s and early 1980s.

Paul Volcker in the early 1980’s (former Fed chair: 1979-87) crushed inflation by hiking interest rates to a staggering ~19+%.

Gareth Soloway on Twitter: “With the #FederalReserve likely to raise rates by 25 basis points tomorrow, whatever the near-term whip of this is, the 10 year #yield chart shows upside will likely continues over the next few months til 2.40%-2.50% is tagged. #ChartAnalysis #TechnicalAnalysis #Bonds pic.twitter.com/kqIzPLMRSa / Twitter”

With the #FederalReserve likely to raise rates by 25 basis points tomorrow, whatever the near-term whip of this is, the 10 year #yield chart shows upside will likely continues over the next few months til 2.40%-2.50% is tagged. #ChartAnalysis #TechnicalAnalysis #Bonds pic.twitter.com/kqIzPLMRSa

Raising rates is the only Option for the Federal Reserve

With inflation now running as hot as it is, the Federal Reserve has little choice but to raise rates in the near term. Every analyst and Fed policy watcher is currently falling over each other to project the maximum number of rate hikes (up to 7 in some forecasts!). 

Powell will have the Administration’s backing: After a period of relative popularity in the early months of his term, Joe Biden now has terrible approval ratings. In the upcoming midterm elections, this November most political observers project a bleak outcome for the Democrats and Joe Biden.

One of the top issues for the voters is a state of the economy. While unemployment today at ~4% is much better than 14.7% at peak of the shutdowns in Apr 2020, many feel pessimistic due to high inflation and persistent supply chain issues. While actual wages have gone up they are running behind inflation numbers meaning people on a net basis are earning less than before.

Biden reading the political tea leaves knows that Democrats will be up against a “Red/Republican tsunami” in the midterms if they don’t tame inflation soon. He has said many times including publicly that bringing inflation under control is one of the main tasks for the Fed. With political mandate/full backing from the President in theory Powell’s job should be easy to hike interest rates, stop QE (Quantitative Easing) and reduce the Fed balance sheet.

Hiking rates could have side effects increasing pressure on the Federal Reserve

But tapering off QE and hiking interest rates will not be easy.

The highly leveraged financial system today has become accustomed to easy money since the 2008 GFC.

Back in mid-2017, former Fed chair and current Treasury Secretary Janet Yellen compared the Federal Reserve’s balance sheet reduction to “watching paint dry” (i.e. will be boring and uneventful). Fed had raised the interest rates from near 0-0.25% in 2015 all the way up to 2.25-2.5% when the stock market in Q4 2018 crashed by 20%. This forced Jerome Powell to pivot and start reducing rates again. A stock market correction of 20% had essentially forced Powell’s hands to change the policy of tightening and balance sheet reduction. So much for what was called to be as boring as “watch paint dry”.

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The Stock Market is most worried with what the Federal Reserve will do

Fast forward to today when the stock market is 8+% below the all-time highs seen in the 1st week of January. Many economic indicators are also flashing warning signs signaling that a slowdown is likely.

  1. Consumer confidence is at a decade low
  2. US PMI fell for the 3rd straight month (Purchasing managers’ indexes are economic indicators derived from monthly surveys of private sector companies)
  3. Credit card debt had largest quarterly increase in past 22 years (probably as money from the stimulus has been spent)
  4. After growing on an average ~5+% for the past 5 quarters, the GDP forecast for Q1 22 as per Atlanta Fed GDP estimates is a measly 0.7%

This is the macro environment backdrop in which Fed is going to be forced to hike rates and taper into.

There is also the thorny issue of how much to raise rates by and how fast to go about it. St. Louis Fed President Jim Bullard a hawk on the Federal Open Market Committee (FOMC: the Federal Reserve’s chief monetary policymaking body) has favored a 50bps rate hike in March 17 FOMC meeting and a 100bps rate hike by July. Fed has to “thread the needle” where they have slow inflation while also not throwing the economy in a tailspin as a result.

The Federal Reserve has been so far behind the curve on these rate hikes that they are now forced to play catch up by going more aggressive now. Basically, they have to slow down the car to control inflation but also not slam the brakes so hard that they throw the passenger (i.e. economy) through the front windshield.

The Stock market spooked by rate hikes might sell off even more triggering a possible bear market like it did in Q4 2018 (the last time Fed tried to taper). But the economic situation in late 2018 was much better to withstand a shock from such a selloff in the market.

A deep decline in the stock market along with slower economic growth and consumer spending might force companies to rethink their long-term spending plans which could possibly lead to layoffs down the line. This being an election year Biden would not want the robust job creation under his watch to vanish just before the midterms when that is one of the few positives of his term so far.

Rising interest rates also mean that debt becomes harder to refinance. An economic slowdown pushes companies that are not doing great to now to have to take on even more debt due to twin pressures of declining revenues due to the slowdown and rising interest payment for the new debt at higher interest rates. Rates rising too much in such a deflationary environment would push some of them into bankruptcy. Rates can only be pushed so much higher in a highly leveraged/indebted world before the system could potentially collapse.

The inversion of the 2-year and 10-year treasury yields (i.e. how much the 2-year treasury note and 10-year interest payments are) has been a harbinger of upcoming recessions. (e.g. the 2/10 inverted in the summer of 2019 foreshadowing the 2020 crisis). This inversion has correctly foreseen around 8 recessions in the past half-century. The spread/delta between the 2/10 is now at its lowest since April 2020 (i.e. yield curve has “flattened”).

The Federal Reserve is attempting to find a balance between Inflation and Recession

The Federal Reserve hiking aggressively in the face of the 2/10 yields can easily cause this curve to invert which could mean that the bond market is signaling a recession down the line which is unwanted by any politician in an election year. There also remains an outside chance the 2/10 spread might invert even before the March 17 FOMC meeting.

This would leave Fed in a pickle where hiking rates maybe just exacerbate the deflationary/recessionary pressures down the road. Unlike Q4 2018 when the Fed intervened to save the stock market due to the “taper tantrum”, Fed will have to hike rates irrespective of the fact that so they can get a hold on inflation prints later this year.

Jim Bianco of Bianco Research LLC recently said that 40% of Americans have just $1000 of savings with them. These folks at the lower end of the economic strata would be more worried about runaway inflation than a stock market being down 20+%. Fed can’t be seen as intervening again to save the stocks from falling and in effect “bailing out the top 10%” who own ~90% of all stocks. On the political side optically, it would look terrible for the administration if the Fed is seen as intervening again to save the stocks from falling and in effect “bailing out the top 10%” especially when wealth inequality is a major talking point politically.

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Given the political directive to bring inflation (that affects all Americans irrespective of their political affiliations or economic class) under control Federal Reserve, for now, has made it a priority to tackle inflation over anything else (i.e., propping up the stock market). Fed will likely be on the sidelines till a 20% correction as they would not mind the “excess froth/exuberance” the market wearing off.

On the other hand, a stock market crash that would follow reduced liquidity will eventually percolate to the rest of the economy and force the Fed’s hand. One must remember that when the market was down 30+% in late March 2020 Fed was throwing the proverbial “kitchen sink” to stop the decline in the market with massive purchases, liquidity measures, etc. including an unprecedented move to buy corporate debt!

Any selloff will not only cause pain for the top 10% of Americans who own majority of the stocks but also the baby boomers who have retired and have a significant proportion of their wealth in 401k which is tied to the stock market in most cases. An estimated 1-3 (as per various estimates) million baby boomers who retired early seeing handsome gains over the past 18 months might also have to potentially return to work.

There also remains a risk that seniors being one of the most reliable voting blocs (compared to younger folks who don’t vote as much) expressing their frustration with their retirement portfolios getting hit hard by voting against the incumbent politicians.

FOMC members can make all the noise about multiple/steep rates hikes but this will last only until something goes awry. If this triggers a recession or some sort of financial crisis, the “crush inflation” mandate might be forgotten in a jiffy in the interest of “saving the economy” (i.e., Reverse course on a dime). With each financial crisis, it has gradually taken a lesser amount of threshold for something to break which forces the Fed and other central banks to reverse course.

While the talk of 6-7 potential rate hikes in 2022 might be easy to make now only time will tell if Fed can walk the talk on so many rate hikes, without causing any kind of pain or disruption in the larger economy. In case of such an eventual U-turn once more liquidity is injected into the system, this can potentially “turbocharge” inflation to even higher levels than today.

While stocks and other kinds of hard assets would rally to the upside this would benefit the asset holders of these assets. But this could very well anger the rest who will have again have to bear the brunt of even more inflation with not many hard assets as a hedge against unchecked inflation.

The Fed is now truly stuck between a rock (where they hike interest rates and do QT which combats inflation but can very well result in a financial crisis and/or stock market selloff triggering an economic downturn) and a hard place (where either during the current slowdown and/or after a future economic crisis they again start providing liquidity to allow growth to rebound but causing even more rampant inflation than what we are seeing right now) Irrespective of which path they choose there are problems to come down the road leaving the Fed trapped with no good choices here.

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