Markets’ shaky start to the year is more than a little due to the expectation that the Federal Reserve may raise rates over the coming months. By the end of the year, it could also shrink its large balance sheet.
Given what happened to assets the last time the Fed was involved in monetary tightening, one can realize why investors are nervous. As this chart from Deutsche Bank’s excellent Jim Reid highlights, the last period of Fed tightening, in 2017/18, was followed by the highest percentage of asset classes ever that recorded negative total returns. Eeek:
As Reid puts it:
Timing is almost impossible to get right without a little luck, but if the Fed starts a series of rate hikes and QT as aggressively as it seems likely, the likelihood of major market corrections at some point is likely. .
There may be even more noise this time.
Debt burden is now significantly higher. The Institute of International Finance’s Global Debt Monitor measured global debt at just shy of $ 300tn, or 350 percent of GDP, in the third quarter of 2021. Of about $ 250tn, or about 320 percent of global GDP in 2018.
Add to this the wave of operations in more shady sectors such as crypto, and it’s not hard to imagine that an awful lot of people, businesses and governments are being exploited to the extreme. Even relatively small changes in price and amount of credit can have a big impact on prices. As margin calls are made, a vicious cycle of fire sales – and further calls – can arise.
On top of that, there is another risk. If inflation continues, the magnitude and pace of Fed tightening could exceed current expectations.
The federal fund rate is now about eight percentage points lower than it was the last time inflation was north of 6 percent:
This is before we get to the increase in size of the balance sheet. Here’s how it has been ballooning since the Fed’s current time series began in 2002:
It may well be that, with debt as high as it is, credit may not have to be as expensive as in the past to curb demand and tame inflation. But, like Edward Price warn here, the real federal fund rate for the real economy can still be much higher than markets can endure.
With the Greens team approaching its 35th birthday, the assumption that U.S. monetary policymakers will undo the strain if there is market turmoil is baked into investors’ mindsets.
But nothing lasts forever. Decades of low inflation have given US central bankers room to soothe investors’ nerves. At some point, price pressure will become endemic. When they do, the Fed’s tune could change in a more radical way than markets expect.