Why Federal Reserve’s hard pivot over inflation has stock markets spooked

Investors are worried the policy support freely offered by central banks in the past two years will be withdrawn quickly and aggressively
Market volatility is expected to persist until there is greater clarity about the pandemic, snarled supply chains and the direction of interest rates

Kerry Craig

Published: 10:15pm, 4 Feb 2022

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Capital markets have had a turbulent start to the new year as they adjust to more active central banks and tighter monetary policy. The US Federal Reserve has kick-started the hawkish tones, and other developed market central banks are following suit. Higher interest rates are not a negative given they signal a stronger economy, but the pace of increases could be if rates move higher in quick succession.

It turns out the only thing transitory about inflation in the United States was the use of the phrase “transitory”. Based on the Fed’s January meeting and the increasing rhetoric from committee members in the subsequent days, inflation is an issue that needs to be addressed soon. The market reaction to this news should be viewed in the context of state of the US economy and the starting point of monetary policy.

The US economy is in remarkable shape. Jobs are plentiful for those who are looking for them, wages are rising and helping to offset some of the increased cost of living from higher prices. Meanwhile, companies are planning to spend and invest as demand looks strong and they seek to improve productivity.

Then there is the very easy stance of monetary policy from which the Fed is starting. Even if the Fed raises rates five times this year, the official cash rate will only be around 1.25 per cent in nominal terms and remain negative in real terms, or adjusted for the rate of inflation. They would still be some way from where they would be high enough to really hamper economic activity.

So why have equities reacted so sharply to the prospect of higher rates? It’s because of the pivot.

In March 2020, the Fed and other central banks pivoted quickly to cut rates, buy bonds and provide liquidity to the financial system to stem the negative economic consequences of the Covid-19 pandemic. However, equities and credit markets quickly rose with all this policy support. Investors now fear the reverse will occur as the Fed pivots in the other direction.

The loosening pivot was aggressive and swift, and the Fed did things it had never done before, such as purchasing corporate bonds. While the recent pivot to tighter policy might be more assertive than what was expected a few months ago, it is relatively gradual in comparison to both historical rate rise cycles and how fast the Fed was willing to loosen the reins.

Increased uncertainty about how high bond yields might rise and how much monetary conditions will need to tighten has caused the sell-off in equities. Assets most highly valued in the US, such as technology stocks, are falling the most.

However, the lower valuations across equities will eventually entice investors back to the market. This is especially so in an environment where the probability of recession remains low and earnings robust, even if the most profitable part of the equity bull market has passed.

The movement in bond yields will be critical for risk assets as monetary conditions shift from something that has been hyper-accommodative to a less supportive stance.

Some broad trends should remain, such as the rotation towards cyclical and value sectors as yields rise. Earnings in those sectors still have room to catch up from changing consumer spending habits and higher energy prices.

But equity markets are likely to be more volatile until there is more clarity that the global economy has passed the Omicron wave, supply chains are on the mend and inflation rates start to fall back from their elevated levels in the US. This would ease some of the risks around an over-tightening of financial conditions and an early closure of this period of the economic cycle.

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The increased volatility means market participants might also have become more active in their strategies. Plain-vanilla investment strategies are likely to generate lower returns in the future than the past two years. Investors might have to be look towards strategies that are more nimble and able to use the volatility to their advantage.

As for government bonds, their appeal is limited given the outlook for rising yields. But risks of the economic outlook remain from a more pronounced slowdown in China or geopolitical tensions that cause a supply shock in the oil market. With this in mind, bonds still hold a diversification role in a portfolio during periods of market turbulence and in the face of such risks.

Kerry Craig is a global market strategist at JP Morgan Asset Management

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