Card Game Helps Clarify Fed Speak

During a recent corporate retreat, I had the opportunity to learn and play a card game called “Burn Your Neighbor” with several colleagues. I was reminded of two things. You can evaluate people’s risk-taking personality during a one-hour card game better than you can from our standard risk profile questionnaire. People’s tells are easily identifiable, and we need to be more attune to them when discussing their investment strategies.

The game was simple enough: you’re dealt one card, high card wins, low card pays the pot. If you don’t like your card, you pass it to the person on your left—hence the name of the game. When your neighbor passes you a two, you either pass it along or are stuck with it, knowing you haven’t a chance. If the person to your left has a king, they can leave you holding the low card.

Investing is like that. You need to get rid of your low cards quickly and hang onto the high ones, and this activity is dependent upon how the economy and markets move over time.

The economy and markets move through cycles. The cycle of ups and downs is consistent over time; however, the pace varies continuously, and the catalysts to move from one part of the cycle to the next are also never the same.

Fed Speak

The pandemic has created a compressed time horizon for the current economic cycle. We’ve gone from a deep recession to a roaring comeback in a matter of 12 months. As a result, the types of investments that do well throughout an economic cycle, which normally unfolds over years, have changed rapidly. We see this today following this week’s Federal Reserve statement.

For the last year, Fed Chairman Powell has said the Fed isn’t even thinking about changing interest rate policy. Meaning, it believed that short-term rates would remain near 0% for an extended period of time. Markets took this to heart and built in a “lower for longer” interest rate scenario to price all assets.

This week, the Fed changed their tune and said, “we’re talking about interest rates” and indicated that it believes rates will rise in the latter half of 2023. While not immediate, the market understood this to mean that it should begin preparing for the next interest rate regime, and we saw asset prices in many market segments adjust accordingly.

The Cycle

Because of the compressed time horizon for this economic cycle due to an immediate pandemic shutdown, very fast vaccine roll-out and reopening, and unprecedented stimulus, the normal cycle for Fed interest rate movement has been harder to predict.

When a recession takes hold, the Fed lowers interest rates to reduce the cost of capital, improve financial conditions and make it easier for the economy to recover. This time, rates were already very low and the Fed was accompanied by tremendous (read in the trillions of dollars) federal spending to offset the economic decline resulting from the pandemic. The Fed bought over half the debt issued for this spending, which has ballooned its balance sheet to $8 trillion from near $3 trillion.

In other words, the Fed used much more than interest rates to deal with this fast recession, so interest rate policy has taken a back seat to their other activities, giving investors comfort that they wouldn’t change much.

That may have ended this week. The Fed is indicating that its two mandates, controlling inflation and achieving full employment, are starting to come into conflict. That is to say that inflation has risen beyond the target level (last year the Fed said it may allow that for 12-18 months) and that unemployment levels are returning to normal. Still, the Fed is buying more than $120 billion a month in bonds, so telegraphing to markets that this will have to be absorbed elsewhere when it begins to buy less is delicate. In addition, it noted the potential for higher rates in 2023.

Markets’ reaction was swift, with stocks that benefit from higher rates rallying, stable growth stocks taking over from value stocks (an indication that markets are looking past the fastest part of the economic recovery) and short-term interest rates moving higher (the 2-year Treasury yield rose 60%...although that was from 0.15% to 0.24%).

No doubt the Fed will continue to provide insight into its desire to reduce bond purchases and the timing of the next rate hike. However, the direction of the economy and inflation is not cast in stone, as there are many factors affecting outcomes. That may mean heightened volatility and many opportunities to take advantage of the faster cycle.

We’ll keep passing our low cards and holding on to our high ones.

ABOUT THE AUTHOR

Brian Andrew

Chief Investment Officer | Johnson Financial Group

As Chief Investment Officer, Brian Andrew leads Johnson Financial Group's investment strategy to provide consistent, actionable investment solutions for our clients.