Hikes and Tapering

Market Memo

 April 2022 – By Kyle Rohrwasser

Russian President Vladimir Putin says peace talks have reached a “dead-end situation” after Ukraine made allegations about war crimes. It seems that war in Ukraine will continue as Russian forces shift their focus toward Donbas. The war is weighing on the global supply chain, especially within the global food supply.  The disruption increases the price of the food we eat and the inputs needed to successfully grow that food, such as fertilizer and herbicide. As of the end of last week, 2022 returns for most equity sectors are negative.  Energy is a notable standout but unsurprising given the recent global events driving energy prices higher.   

The war overseas wages on as the Federal Reserve gears up to fight its own battle against inflation. The latest report revealed that inflation rose at the highest rate since 1981. The Bureau of Labor Statistics (BLS) Consumer Price Index (CPI) rose 8.5% in March compared to the same month last year; food, shelter, and gasoline were the biggest contributors to that rising number. Predictably the Fed has admitted being behind the curve and is prepared to move quickly regarding rate hikes. There would be no surprise if we saw a 0.50% rate hike in May, double the increase seen in March.  The bond market responded with the 10-year treasury yield increasing to 2.7%, a 27% move in a month’s time. In addition to the rate hikes, the Fed also plans to reduce the balance sheet which will contribute to monetary policy tightening.

Throughout much of the previous decade, the Fed was engaged in what is known as Quantitative Easing, or QE for short.  Simply put, the Fed was providing liquidity to the marketplace by buying a set number of securities per month, mostly U.S. Treasuries and mortgage-backed securities.  This action helped keep rates low in an effort to stimulate the economy, but it also caused the Fed balance sheet to swell to trillions of dollars.  When the pandemic hit, the Fed supercharged this tool by buying billions of securities each month.  The Fed was once again able to help the economy through a difficult time, but nearly doubled the size of the balance sheet in doing so.  Now the Fed is looking to taper its balance sheet as a shift in strategy to combat inflation in a process known as Quantitative Tightening (QT).

Therein lies some concern.  There are numerous examples of rate hike cycles throughout market history for investors to study.  We can examine these periods of time for clues and attempt to draw parallels to today’s environment.  The same cannot be said for QT.  Aside from a moment in 2018, the Fed has not attempted to shrink its balance sheet on this scale.  The assumption is that QT will likely push rates higher, but the degree and pace is unknown.  The Fed has signaled they will ease into the program over 3 months, eventually settling at shrinking the balance sheet at a pace of approximately $95 billion per month. 

The Fed has a difficult road ahead as the backdrop for continued inflation remains strong and finding that sweet spot of slowing growth and avoiding recession is growing more difficult.  Since the onset of the pandemic, we have seen an emergence of a more reactive Fed that is willing to pivot as the data changes.  We find this encouraging as it enables the institution to respond quickly to changes in the current economy.  The Fed’s campaign of tightening monetary policy is just underway, and the team at Vantage will continue to closely monitor how it progresses as we seek out potential opportunities.  

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