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Blog: The Powell Put

By Jeff Pollock

As 2021 draws to a close, many are eagerly forecasting the market’s direction next year.

We expect the monetary policy adopted by the US Federal Reserve to be a major variable that will impact the market in 2022. The Fed has a dual mandate to promote stable prices and maximum sustainable employment. With inflation above 6% and unemployment only slightly exceeding 4%, market strategists presently expect three rate hikes to occur during in 2022 (March, July, and December).

Higher interest rates have historically accompanied lower stock prices. This is because fixed income alternatives become more appealing to income-seeking investors and future corporate earnings become less valuable when discounted back to today. However, history also demonstrates that stock prices exhibit erosion only when the Fed moves too quickly to hike rates.

We don’t believe there will be three rate hikes in 2022, which is a bullish indicator for stocks moving into the New Year.

Jerome Powell became the Federal Reserve’s Chair during February 2018 after a successful career in private equity and investment banking. It is often said that “the right leader comes at the right time.” Mr. Powell’s successor, Janet Yellen, was widely regarded as an expert on labour force dynamics. During her tenure, the rising inequalities between rich and poor attracted unprecedented attention. Prior to Yellen, Ben Bernanke was appointed in 2006 after studying the Great Depression for much of his career. Two years later, the financial crisis put his expertise to good use.

As someone who spent his career working in capital markets, we believe that Mr. Powell will closely adhere to historical precedent and moderately raise rates rather than pursue an aggressive timetable that would cause stock market volatility and weakened prices.

Two indicators will cause him to act this way.

First, a rise in COVID-19 cases would slow down the timetable to raise rates. Many workplaces were discussing a return to the office in January 2022 until omicron began to spread. Many governments and businesses have now pushed back their plans. Future variants would slow the economic recovery as well as the need to raise rates three times next year.

Second, the mathematical difference between long-term and short-term interest rates at various maturity dates (i.e. the 10-year US Treasury bond rate minus 2-year US Treasury bond rate) is often plotted on a chart called the “yield curve.” When the curve is upward sloping, which suggests the 10-year rate is well above the 2-year rate, the market foresees future economic growth. When the curve is negative, implying short-term rates exceed long-term rates, the market is predicting a pending recession. As Mr. Powell’s policy actions have a greater effect on short-term rates, we do not believe he will aggressively tighten rates and invert the yield curve.

As you can see below in the chart showing the yield curve between 1980 and today, each time the difference between long and short-term rates hit zero, a recession took place shortly thereafter, which is illustrated by the gray vertical bars. The difference between the 10-year and 2-year is 0.75% as of this writing (each rate hike by the Fed is usually 0.25% at a time).

Soon after the first COVID-19 case was announced in North America during January 2020, central banks around the globe collectively cut interest rates. Since then, S&P 500 has appreciated a remarkable 43%. While we expect rate hikes to commence in 2022, we believe that the Fed will fall short of three increases. Unfortunately, future COVID-19 variants appear likely and Mr. Powell’s experience in capital markets will deter him from inverting the yield curve.

Looser monetary policy bodes well for stock prices, even during a pandemic.

DISCLAIMER: The opinions expressed in this publication are for general informational purposes only and are not intended to represent specific advice. The views reflected in this publication are subject to change at any time without notice. Every effort has been made to ensure that the material in this publication is accurate at the time of its posting. However, Schneider & Pollock Wealth Management Inc. will not be held liable under any circumstances to you or any other person for loss or damages caused by reliance of information contained in this publication. You should not use this publication to make any financial decisions and should seek professional advice from someone who is legally authorized to provide investment advice to assess your goals and objectives, personal circumstances, and make an informed suitability assessment.


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