Markets tremble as Fed’s lifeline fades

After falling for the fourth day in a row on Friday, the stock market had its worst week in nearly two years, with the S&P 500 so far in January having its worst start since 2016. Technology stocks have been hit especially hard, with the Nasdaq Composite Index falling. more than 10% from its most recent high, which qualifies as a correction in Wall Street talk.

That’s not all. The bond market is also in disarray: interest rates are rising sharply and bond prices, moving in the opposite direction, are falling. Inflation is red hot and supply chain disruptions continue.

So far, the markets have looked past such problems during the pandemic, which has seen the value of all kinds of assets soar.

Still, a crucial factor has changed, giving some market watchers reason to worry that the recent decline may have repercussions. That element is the Federal Reserve.

As the worst economic ravages of the pandemic appear to be abating, at least for now, the Fed is ushering in a return to higher interest rates. It is also beginning to withdraw some of the other forms of support that have pushed stocks soaring since it intervened to bail out badly injured financial markets in early 2020.

This could be a good thing if it brings down inflation without derailing the economic recovery. But removing this support also inevitably cools markets, as investors move money around in search of assets that outperform when interest rates are high.

“The Fed’s policies have actually triggered the current bull market,” said Edward Yardeni, an independent Wall Street economist. “I don’t think they’re going to end it now, but the environment is changing and the Fed is responsible for a lot of this.”

The central bank is tightening monetary policy partly because it has worked. It helped boost economic growth by keeping short-term interest rates close to zero and pumping trillions of dollars into the economy.

This deluge of easy money also contributed to the rapid rise in the prices of commodities, such as food and energy, and financial assets, such as stocks, bonds, homes, and even cryptocurrency.

What happens next comes from an established script. As William McChesney Martin, a former Fed chairman, said in 1955, the central bank is acting as the adult in the room “who ordered the punch bowl removed just as the party was really heating up.”

The mood in the markets changed on Jan. 5, Yardeni said, when Fed officials released the minutes of their December policy-making meeting, which showed they were on the brink of embracing a much tighter monetary policy. A week later, new data showed inflation soaring to its highest level in 40 years.

By merging the two, it looked like the Fed would have no choice but to react to curb rapidly rising prices. Stocks started a disorderly decline.

The financial markets expect the Fed to raise its key rate at least three times this year and start shrinking its balance sheet as early as this spring. It has already lowered the level of its bond purchases. Fed policymakers will meet next week to decide their next steps, and market strategists will be watching.

Low interest rates made certain sectors particularly attractive, especially technology stocks. The information technology sector of the S&P 500, which includes Apple and Microsoft, is up 54% year-on-year since its pandemic-induced low in March 2020. One reason for this is that low interest rates have reduced the value of the expected future returns of growth-oriented companies. like these. If rates rise, this calculation can change abruptly.

The mere prospect of higher interest rates has made technology the worst performing sector in the S&P 500 this year. It has fallen more than 11% since its high in late December.

In contrast, the three best-performing sectors of the S&P in the early days of 2022 are energy, financial services and consumer staples.

The energy index is dominated by fossil fuel companies, such as Exxon Mobil and Halliburton, whose fortunes have risen along with oil and gas prices. Financial companies may charge more for loans if interest rates are high. Major banks like Wells Fargo have reported record profits in the past week. Consumer companies such as Kraft Heinz and Campbell Soup have lagged behind the explosive growth in technology stock prices earlier in the pandemic, but they have been gaining ground in this new environment.

In general, the stock market has also lost some of its resilience for reasons other than monetary policy. “Stay at home” stocks that thrived during pandemic restrictions, such as Netflix and Peloton, are beginning to weaken as people go out more.

Some astute market analysts foresee bigger problems ahead. Jeremy Grantham, one of the founders of GMO, an asset manager, predicts a catastrophic end to what he calls a “super bubble.”

But current losses could be beneficial if they let a little air out of a potential bubble without bursting investor portfolios. This year’s declines erase only a small fraction of the market gains of recent years: The S&P 500 rose nearly 27% last year, over 16% in 2020, and nearly 29% in 2019.

And the outlook for corporate earnings remains good. Once the Fed starts trading and the securities are better understood, the stock market can move on — at a less dizzying pace.