The Fed’s Vacillation Increases Risk

The Fed’s Vacillation Increases Risk

As we’ve discussed, equity markets started the year on a sour note which lasted until February 11th. Since that time, however, stocks have rallied, bringing the S&P back into positive territory—at least as of this date. While the recent run has been tied to rising oil prices (this coupling won’t last forever), continued contradictory Fed statements could put a lid on any future rallies.

Going into 2016, Wall Street—generally optimistic with its forecasts—expected an 8% rise in the S&P 500. Reaching that target is less likely, now that we have gone through three months and are only at break even. Reducing that probability further is the conflicting dialog emanating from the Fed itself. Wall Street hates uncertainty and recent comments from Fed speakers have only added to the uncertainty. Yellen’s remarks this week, which were a rehash of earlier statements, have been deemed dovish and pointed to a slowdown in rate hikes, while separate statements last week from Atlanta Fed President Dennis Lockhart and San Francisco Fed President John Williams were quite the opposite and very hawkish.

The conflict seems to arise from the predicament in which the Fed has placed itself. In the past I have discussed the Greenspan put, in which investors became accustomed to the Fed stepping in to prop up markets whenever they declined, and as a result, stock prices soared. 2015 saw the Fed stop easing and, not surprisingly, returns on equities were mostly negative.

Now, instead of the Greenspan put, the Fed seems to be taking a different tack. When stocks rise, the Fed dialog turns hawkish, setting the stage for a rise in rates. If the markets react negatively, more dovish comments come out helping to buoy asset prices. Given the growth in the economy, the reduction in interest rates, and the potential for inflation (given oil’s low starting point), the Fed would love to normalize rates. The increase would give them more policy flexibility when the economy takes a negative turn. And although it may seem hard to believe, here in the US we have had six straight years of economic growth. However, given the Greenspan put, the Fed does not want to be responsible for causing stocks to decline.

Should the Fed continue this doublespeak, stock rallies would be short lived. Conversely, corrections would be short lived as well. The Fed would remain in the equity management business, which has worked well for equity investors but it has come with a price. For bondholders, that cost is born in the low yields. And for equity investors it isn’t a free lunch either. Stock prices reflect the expected future earnings of a company—discounted back to reflect the value in today’s dollars. That discount, besides the risk of uncertainty, is based on interest rates. So, as interest rates have fallen, the value of those future earnings has risen, thereby increasing corporate values and stock prices. However, the exact opposite will occur when interest rates rise. Therefore, equity investors who have reaped the benefit of Fed intervention through 2014, have taken that benefit from future returns.

This would suggest a negative bias towards stocks—at least for the short term. And we have previously discussed how stocks are not cheap on a historic P/E basis, though a different argument could be made looking at forward P/E ratios. But let me be clear, we are not in the business of forecasting the S&P—especially in the short term. This type of estimation is a fool’s game. However, with volatility at very low levels, the market is primed for volatility spikes, which translates into selloffs. The Fed’s vacillation only increases this risk. I am not saying to put your money in a mattress, but make sure risk management is an integral part of your investment strategy.


Washington Trust Bank believes that the information used in this study was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation for business or a recommendation of the purchase or sale of securities or commodities.

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