The last couple weeks have demonstrated just how quickly things can turn in modern financial markets. Without question, last week’s FOMC meeting will remain a primary market-driver and subject of debate in the months and years ahead.
Has the Fed Lost All Credibility?
This is the question that investors may now be asking. Last week’s Fed meeting took even the most-dovish expectations and turned them upside down. The Fed’s actions-or lack thereof-could set the stage for significant dollar declines and higher asset prices. Put another way, the central bank is not willing to pop a bubble of its own making.
Not long ago, the Fed seemed willing to take the heat that stemmed from criticism of its ongoing policy “normalization.” Just a few months back, Fed Chief Jerome Powell had suggested that rates had a way to go before entering neutral territory. That opinion changed soon thereafter, when Powell said that rates may be closer to neutral than previously thought. The Fed then went ahead with previous plans to hike the Fed Funds rate by another 25 basis points in December.
The markets did not take the rate hike lightly, and the month of December saw a significant rise in volatility as equity markets suffered steep declines. Although numerous issues such as the ongoing trade war with China and arguably overstretched valuations likely played a role in the stock market pullback, most analysts seem to agree that a hawkish Fed was the primary culprit behind the sell-off.
The last few months have seen a steady stream of Fed criticism, with everyone from Mad Money hostJim Cramer to President Trump voicing their displeasure with the Fed’s course of action. The Fed has tried to maintain its independence, however, and as recently as several weeks ago reiterated its plans for further hikes this year.
Those plans now seem to have been thrown right out the window. In an abrupt about-face, the Fed has not only reversed its position on further rate hikes but has also said it will halt its ongoing balance sheet reduction.
In effect, the Fed has announced that it will keep “priming the pump.” Whether this decision came about as a result of increasing political pressure or significant changes in the central bank’s outlook, the central bank’s reputation is likely to take a major hit.
For investors, however, this makes one key issue crystal clear: The markets simply cannot do without ongoing Fed stimulus.
Not only has the Fed now halted all of its quantitative tightening measures, it has suggested that it may need to start easing again. The problem is, with the current Fed Funds rate at 2.25%-2.50% and the central bank still holding nearly $4 trillion in securities on its balance sheet, the Fed will have little ammunition to fight the next recession.
The smart money seems to recognize this. Recent inflows and bullish price action in the gold market may suggest that many investors see the writing on the wall and are looking to position accordingly. Although stocks may get an initial bump from these developments, the bubble will burst at some point. When it does, look out below. If price action related to previous Fed balance sheet expansion and contraction are a good indication, stocks could eventually decline by 50% or more.
The Fed’s actions are likely to make the next recession longer and deeper than the previous. The central bank’s inability to continue tightening is also likely to cause significant dollar weakness in the process. Any way you slice it, the current environment is highly bullish for gold and recent gains in the yellow metal could simply be the tip of the iceberg.