Fed Fires Warning Shots

Fed Winners & Losers

  • Winners: Financials, Consumer Staples, Travel Stocks, Consumer Discretionary, Retail. 
  • Losers: International Conglomerates, Speculative Stocks & Cryptocurrencies, Utilities, Gold, Commodities, Housing.

Fed Chairman Jerome Powell told us to expect a taper by year’s end.

Markets initially soared on the news, disguising a more disturbing trend.

One that could quickly upend markets.

Fast Facts.

At the online gala, Powell laid out the following:

  • Taper will likely begin before the end of the year.
  • The Fed doesn’t plan to increase rates anytime soon.
  • He gave no pace and timing of the taper.

Since the Pandemic hit last year, the Fed hit the economy with a three-pronged approach:

  1. Lower federal funds rate 
  2. Buying treasuries and mortgage backed securities (MBS)
  3. Buying corporate debt and ETFs
    • In June, they laid out plans to unwind (sell) $5.21 billion in corporate debt in companies like Whirlpool (WHR), Walmart (WMT), and Visa (V) along with $8.56 billion in ETFs that hold similar debt such as the Vanguard Short-Term Corporate Bond ETF (VCSH).

While the Fed ended the corporate debt and ETF purchase program last December, it continues to purchase treasuries and MBS.

Taper defines when they start to curtail those purchases. Last time, the Fed held many of the shorter-dated treasuries until maturity.

However, Powell left the timetable of how long and the magnitude of the taper.

Market Impact

Theoretically, lower demand for treasuries and MBS should lead to higher rates. And normally, bond prices move in the opposite direction of stocks.

However, that may not be true in either case.

Bonds

You see, globally, developed nations like Germany have taken to driving their bond yields below 0%.

The combined quality and yield of the U.S. treasury market may very well attract foreign capital that has nowhere else to go, effectively limiting a drop in bond prices as well as an increase in yields.

Stocks

When the Fed lowers interest rates, the required rate of return on stocks drops.

That means a stock that once required a 10% rate of return now only requires 7%.

Why?

Opportunity Cost.

(Academically) the value of an equity is the risk-free rate of return (IE U.S. government bond yields) plus a risk premium for that stock.

Conversely, when rates rise, so does the required rate of return on stocks.

Historically, investors put money into bond markets to hide when stocks are risky and into stocks when there is less risk.

However, this relationship tends to only hold out under normal market conditions.

Right now, the Fed programs manipulate true supply and demand, breaking down this relationship.

That’s why a sell off in treasuries may very likely lead to a selloff in stocks.

Engage Your Clients Early

Phone calls and meetings are easier when markets perform well.

But they can and will falter.

That’s why macro analysis and planning take precedence over short-term fluctuations.

If only our emotions understood that.

The fact remains that when volatility hits, calls start coming in.

More than regular updates, clients appreciate proactive engagement and communication.

If and when market volatility hits, be ready to be the first to reach out rather than waiting for them to call.

Understand and acknowledge their emotions while keeping things grounded in facts and plans.

Simple gestures like this go a long way to attracting and retaining clients for a lifetime.

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