When it comes to money, there's one group that's
more powerful than every trader on Wall Street.
That would be the government's bank, the
Federal Reserve.
People listen to the Fed and they respond to what
the Fed says about the future.
When you listen to the Fed, you get at least one
studied outlook about what the future's going
to look like.
The Fed's press conferences, held every
six weeks or so, tend to cause swings in the stock
market.
Over time, central banks have moved from being
very secretive about what they're doing to
being more transparent about their policy
decisions. And part of that transparency is
signaling where policy is likely to go in the
future.
The Federal Reserve has hiked interest rates
seven times in 2022.
That's a relatively rapid pace.
This and a historic drawdown in the bank's
bond portfolio is weighing on stocks across
the board.
But there's a lot of other forces that are
affecting the economy.
By the time they usually start trying to slow
things down, it's gotten to a pretty bad
situation.
So how does the government's bank use
words to control stock prices?
And how can investors take a sound bite and
turn it into profit?
Forward guidance refers to public comments made
by leaders of the central bank.
Let's talk about forward guidance in two different
ways. The first way the Fed does forward guidance
is actually a very overt way, which is it tells
you how they think the economy is going to
evolve. The other way the Fed does so is in
language which can be very subtle.
Some economic models say forward guidance is
incredibly powerful.
The idea was that by changing people's
expectations of the future, you can change
their behavior in the present to make the
present better.
Here's how it works.
A member of the voting committee makes a
statement. The statement contains a vague but
definitive description about a forthcoming
action.
We side by side compare the statements that it
released month over month highlighting the
differentiation. And like a word, literally,
people in finance get hung up on a word.
There is a little bit of tea leaf crystal ball
that certainly goes into parsing the Fed words.
Investors cracking the Fed code are listening
for key phrases like:
"softening of labor market conditions"
or
"we expect to maintain an accommodative stance of
monetary policy until these outcomes, including
maximum employment, are achieved."
If you noticed what Powell said during the
pandemic, we're not even thinking about raising
interest rates. That's forward guidance.
When the Fed says, "we're buying $120
billion in securities per month across the
Treasury curve, that's also adding to
accommodation" that's forward guidance.
It's a very powerful tool.
Some of the most potent Fed statements are about
the future path of short-term interest
rates.
The Fed sets the interest rate that it pays on
reserves held by banks, sort of the same way your
bank sets the rate it pays on deposits.
There's this connection between short-term
interest rates that are closely connected to
monetary policy and the interest rates on
mortgages, auto loans, things like this that
would be more relevant to household decisions.
The Fed sets a target for these interest rates
about eight times a year. Over the past 20
years, the target has stayed low, with extended
periods at zero, a historical anomaly.
Economists say that taking this interest rate
below zero is a bad idea.
You can't set an interest rate less than zero
because people would just store cash in their
mattress instead of investing it with you.
And all this was because they didn't see the
ability to add accommodation to the
economy.
So instead, the Fed tries to set expectations with
their words.
Everybody does their best to set expectations going
forward, depending on what this guidance is.
And like the eight words that they change monthly
is something like everybody drools over and
tries to get their crystal ball and say, Oh
my God, that's what they're really thinking.
We would think that maybe you could get a couple of
percentage points. So effectively having -2%
interest rates through these alternative tools.
That said, people at the central bank say many
outside forces affect prices in markets.
It's not the case that the Fed can perfectly
control how investors or markets will respond to
its statements.
As you saw in 2022, when expectations were behind
the curve and suddenly they had to change policy
very quickly and very rapidly, the markets did
not like that at all and sold off very hard
because then there was this disconnect.
Stock market investors haven't always gotten
such explicit guidance from central bankers.
As subtle as you think it is now, it was way more
subtle way back when.
First of all, there was no forward guidance.
They never even put out a statement until the
early nineties. When you go back to that time
period, this is actually overt and hitting you
over the head.
You go back to the seventies and the
eighties, the Fed didn't talk about its policy
publicly very much at all.
It would finish a meeting in which it
decided to change the stance of interest rates
and it wouldn't tell anyone until eight weeks
later.
Forward guidance became an official policy tool
in the 2000s.
I would say that's in part due to Chairman
Bernanke's leadership, but also in part due to
the exigencies of the situation, of the
episode that occurred under his watch.
As an unprecedented housing crash developed
into contagion on Wall Street, the Fed took
interest rates to zero.
There's this constraint of zero.
And so instead of going lower, the FOMC included
language in their policy statements that interest
rates would remain low for a considerable
period.
People generally think that this had a positive
effect on our economy during those tough years.
And when you're sitting there at the zero lower
bound without an ability to lower interest rates
any further, any port in a storm.
If this has some theoretical possibility
of working, great.
In addition to forward guidance, the Fed tried
another new technique.
Large scale asset purchases or LSAPs.
The asset purchases swelled in Ben Bernanke's
time and nearly reached $9 trillion in the
pandemic. Now the bank is letting some of those
bonds mature.
It's what they're doing with their balance sheet
really matters. And I don't think they're ever
going to get their balance sheet back to
where it was pre 2020.
Central bankers know this technique could have
drawbacks.
Including the risk of impairing the functioning
of securities markets and the extra
complexities for the Fed of operating with a much
larger balance sheet.
Though I see both of these issues as
manageable.
Probably the balance sheet has more of an
impact on stocks than even interest rates in
that the balance sheet purchases or quantitative
easing provides liquidity to markets that
finds its way into stocks and ends up
increasing values. And so reducing that balance
sheet, quantitative tightening, probably has
a bigger impact on the stock market as changing
interest rates.
Much of the modern economy depends on the
Fed's ability to control narratives.
Well, central bankers, they want to have
credibility. They want to be believed.
One way to do that is to say what you're going to
do and then do it.
Some central bank policy makers, though, worry
that doing that will tie their hands too much.
They'd like to have the flexibility to respond to
unforeseen circumstances.
The bank did use this technique before the
Great Recession, however .
For example, the Fed provided forward guidance
as stagflation took hold in the 1970s and early
eighties.
The Fed did learn lessons from the seventies not to
ignore inflation until it becomes too big of a
deal.
But a failure to restore price stability would
mean far greater pain.
Powell has been indicating more recently,
Hey, trying to wake the market up and say, Hey,
this is not something we want to reverse on, which
was a mistake in the seventies and eighties.
And he has referenced that multiple times.
Wall Street's current down cycle kicked off
with a rare admission at the Fed.
It waited too long to act on inflation.
I fear that they took a gamble that inflation
wasn't too real at the beginning of 2021.
I think they know they gambled and lost and that
they have to do something serious in
order to get inflation back under control.
Even when the Fed pivoted rhetorically, as in the
language we were talking about, when it comes to
forward guidance, which Powell did, I believe, on
November 29th or 30th of last year.
It didn't really pivot very quickly in policy.
Rates went up on talk, and that is the power of
forward guidance. So the Fed played a bunch of
catchup. And what it did was it raised rates as
aggressively as we've seen since the 1980s.
As a result, the market has trended downward for
months.
To put it simply, the higher interest rates,
the lower relative value stock prices have.
These companies that year over year were producing
20% returns that people felt so comfortable with.
And then suddenly the giants of the investment
industry started to fall. You had Apple and
Amazon, stalwarts, making tons of money for
decades, suddenly down 40%, 50% on the year.
Tesla is down 50%.
Got some a little bit. Microsoft's held up a
little bit better. When rates are going up, we're
going to see some harder times, which then means
maybe stocks that aren't going to make as much
money.
Some speculators in the stock market hope that
the bank will pivot from that plan.
We do think the Fed is going to pivot harder
than they're saying right now.
The pivot has been redefined three times.
First, the pivot was one with the Fed pivot to
cutting rates. Then this pivot was defined as when
would the Fed pivot to pausing its rate hikes.
Now we have another definition of pivot out
there, which is when will the Fed pivot to
reducing its its rate hikes.
Chair Powell has talked about getting rates
higher and keeping them there longer, and yet the
market still seems to be holding out hope for a
pivot. And so I think t here is a disconnect.
It's been going on for some time.
Many Wall Street advisors have a suggestion" don't
fight the Fed.
The Fed has the thumb on the scale.
So if you have somebody that has a thumb on the
scale or has a decided advantage about what's
going to happen, whether we think good things or
bad things are going to happen, it's best not to
fight that policy. So when the Fed is evening
or the Fed is holding rates at zero, don't
fight it. Run. Take all the risk you can.
It's great. Now when the Fed is hiking and slowing
things down again, the reverse is don't fight
them. Things are going to get bad.
The challenge is interpreting what the
Fed's messages actually mean.
There are multiple possible interpretations
of the Fed's statement that it's going to keep
interest rates low for a long time, and in some
cases, people may also have uncertainty about
what the Fed's ultimate goals are.
That uncertainty came back a little bit in the
pandemic.
The change in market sentiment far outpaces
the change in the rhetoric that actually
comes to the Fed. The big risk is one where
market sentiment decides that they've heard
something different from the chair or from the
FOMC as a whole.
Economists now debate the effects of the forward
guidance technique.
The limits of forward guidance refers to what
we can and cannot accomplish by talking
about the future. Figuring out exactly what
the Fed's viewpoint is is not always easy.
To figure out what the Fed is thinking about the
economy, you've got to sort of read the tea
leaves. That's the dot plot.
Imagine you got up every morning and you could
predict how your day was going to go.
Well, because the Fed controls monetary policy,
it pretty much can predict outcomes, or at
least it feels it has the ability to do so.
At the Federal Open Market Committee meetings
in Washington, D.C., central bankers come
together to set interest rates and construct data
sets like this.
This chart is called the dot Plot.
It's published quarterly in the Fed Summary of
Economic Projections.
The dot plot is this really arcane way of
looking at Fed funds.
Literally every person on their board goes and
picks their dots.
The dot plot shows where each Open Market
Committee member thinks interest rates will be in
the future. In September of 2022, most committee
members saw interest rates rising in the
coming year. By December, most of the
committee saw rates staying higher for
longer.
History cautions strongly against prematurely
loosening policy.
Now, right now they're tightening.
So again, that's why we're not taking a lot of
risks. Don't fight them if they're trying to make
things harder in the world, like that's not
good for profits.
Following the Fed's guidance, Americans are
prepared to pay more for loans in the short term
while their assets stay priced relatively flat.
But ultimately, longer term interest rates are
going to do what they do based on the beliefs of
every participant in the market and how they
interact in a market setting.
I can look at what the Fed says and that might
affect my personal beliefs.
Ultimately, I have to take the rates that the
market gives me. So sure, don't fight the
Fed. But don't believe too much that the Fed is
all powerful.
I don't think folks at home should be trading on
the Fed. I think they should be trading for the
long term. And the long term is that the economy
grows and stocks go up and that's the way to
invest. But if you are going to put that into
your suite of information, there's a
lot of information there about where the Fed
thinks the economy is going to go and what the
Fed is going to do with interest rates.
If they took away forward guidance, your interest
rate announcements or policy decision
announcement would cause mayhem.
Especially if it's very unexpected or there was a
policy change. So I think it's important
because they're looking for stability.