Client Question of the Month

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SEPTEMBER 2021 CLIENT QUESTION OF THE MONTH: THE FED

Client Question of the Month |

by Andrew Murphy, CFA Co-Chief Investment Officer

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The Fed has implemented an extraordinary amount of monetary stimulus to help the economy recover from the pandemic. In our opinion, the Fed’s actions are mostly responsible for the rebound in the stock market and for avoiding an economic crisis. Despite all the press coverage, the Fed’s impact on the economy and financial markets is not well understood by many investors.

In our September Client Question of the Month, we will provide an overview of the Fed and detail why monetary policy is so important to the economy, interest rates, and stock prices.

OVERVIEW

The Federal Reserve, or simply the Fed, is the central bank of the United States. After the Financial Panic of 1907 and several bank failures, Congress decided that the country needed a central bank to act as the lender of last resort. As a result, the Fed was created by the Federal Reserve Act of 1913 and was signed into law by President Woodrow Wilson. The goal was to provide the nation with a safe, flexible, and stable monetary and financial system. The Fed is an independent government agency, but they are ultimately accountable to the public and Congress. While the President or members of Congress sometimes openly criticize the Fed, politics are not supposed to influence their decisions.

The Fed performs five key function to promote the effective operation of the US economy:

KEY ENTITIES

The three key entities of the Federal Reserve are the Board of Governors, the Federal Reserve Banks, and the Federal Open Market Committee (FOMC).

Federal Reserve Board of Governors
The board serves as the governing body for the Federal Reserve System. The Board of Governors are comprised of seven members who are each nominated by the President and confirmed by the Senate. Each member is appointed to a 14-year term, which are staggered so that one term expires on January 31st of every even number year. After serving a 14-year term, a board member cannot be reappointed.

The Fed Chair and Vice Chair are also appointed by the President and confirmed by the Senate. Both serve 4-year terms and may be reappointed. Fed Chair: Jerome Powell Fed Vice Chair: Richard Clarida

Federal Reserve Banks
The twelve Federal Reserve Banks act as the operating arm of the Federal Reserve System. Each of the twelve Reserve Banks operate within their own specific geographic region. The core functions of the Reserve Banks are to supervise financial institutions, offer lending services, and provide payment system functions to banks within their area. The Reserve Banks also collect data and information from their local communities and pass their findings to the FOMC as an input for monetary policy decisions.

Federal Open Market Committee (FOMC)
The FOMC sets the national monetary policy on behalf of the Federal Reserve System. The FOMC is comprised of twelve voting members: the seven members of the Board of Governors, the President of the Federal Reserve Bank of New York, and four of the remaining eleven Reserve Bank presidents who serve one-year terms on a rotating basis. All twelve Federal Reserve Bank presidents attend FOMC meetings, but only voting members determine policy decisions.

The FOMC sets monetary policy through the use of traditional and nontraditional tools to achieve the three goals outlined by their statutory mandate from Congress.

THE FED’S BALANCE SHEET

The Fed’s balance sheet is the consolidated amount of assets and liabilities for all twelve Federal Reserve Banks. Assets include holdings of Treasuries and mortgage-backed securities (MBS), loans to other financial institutions, and the liquidity facilities. Liabilities include currency in circulation and bank reserves (deposits held at the Federal Reserve). Monetary policy has a direct impact on the size of its balance sheet. Generally, accommodative monetary policy will lead to a larger balance sheet and vice-versa.

Prior to the financial crisis, the Fed’s balance sheet did not receive much attention from the financial community. However, once the Fed launched their quantitative easing programs to help the economy recover from the crisis, the balance sheet began to receive a lot more focus. Mainly due to their purchases of Treasuries and mortgage-backed securities (MBS), the Fed’s balance sheet grew from about $900 billion in early 2008 to over $4.5 trillion by early 2015. The Fed began tapering the size of the balance sheet from 2015 through 2019. Due to the programs announced to help the economy during the coronavirus period, mainly asset purchases and new lending facilities, the Fed’s balance sheet now stands at over $8 trillion. Please see our Client Question of the Month on the federal debt.

CONTROLLING THE MONETARY BASE – PRINTING MONEY

The Fed has direct control over the monetary base, which is the sum of currency in circulation plus bank reserves. When the Fed wants to inject liquidity into the economy, they can increase the monetary base by printing money, either physically or digitally. Physically printed money is distributed through the Federal Reserve banks. Digitally printed money occurs when the Fed buys bonds and credits bank reserves. For example, assume the Fed buys a Treasury bond from a bank. The Fed will take ownership of the bond and credit the bank’s reserve account for the corresponding amount.

Bank reserves are cash held in the vault or deposits at regional Federal Reserve banks. The Fed started to pay interest on reserves on October 1, 2008. The current interest rate on reserve balances (IORB rate) is 0.15% as of 7/29/21. Banks can choose to earn interest on their reserves held at the Fed or to lend the funds out into the economy.

HOW MONETARY POLICU IMPACTS THE ECONOMY, INTEREST RATES, AND STOCK PRICES

My job continues to be to predict the financial markets, particularly the major stock, bond, commodity, and foreign exchange markets around the world. To do this job well, I’ve learned that nothing is more important than to anticipate the actions of the Federal Reserve System’s Federal Open Market Committee (FOMC), which sets the course of monetary policy in the United States.”

Ed Yardeni, Market Strategist

The FOMC sets monetary policy to establish the financial conditions they believe will best achieve their three mandated goals of maximum employment, stable prices, and moderate long-term interest rates. As conditions in the economy change, the FOMC will adjust monetary policy accordingly. The Fed’s most commonly used monetary policy tool is adjusting the federal funds rate. Accommodative monetary policy occurs when the FOMC is trying to boost the economy, while restrictive monetary policy occurs when the Fed is trying to slow the economy (typically because inflation is running higher than preferred).

According to the Fed, monetary policy directly affects interest rates; it indirectly affects stock prices, wealth, and currency exchange rates. Through these channels, monetary policy influences spending, investment, production, employment, and inflation in the United States. Effective monetary policy complements fiscal policy to support economic growth.

ECONOMY

The Fed states that monetary policy affects the US economy primarily thought its influence on the availability and cost of money and credit. The Fed’s decisions will impact a wide range of spending decisions by individuals and corporations. When the Fed shifts to accommodative monetary policy and lowers the federal funds rate, lower interest rates will stimulate greater spending on durable goods. Since consumer spending drives about 70% of GDP, a decrease in interest rates that elicits increased spending will boost the economy.

The Fed also points out that higher stock prices will also lead to increased spending due to the wealth effect. When stock prices increase, shareholders’ overall wealth increases. Intuitively, when individuals feel wealthier, they spend more money.

INTEREST RATES

Short-Term
The FOMC generally controls short term interest rates by setting the federal funds rate. As the federal funds rate increases or decreases, US Treasury bills, commercial paper, and other short-term bonds typically follow.

Long-Term
Normally, the FOMC has an indirect impact on long-term interest rates. Usually, the market controls long-term rates as investor demand varies based on future expectations of inflation and economic growth. However, if the FOMC wants a more direct impact on long-term interest rates, they will conduct quantitative easing to purchase bonds in the open market.

STOCK PRICES

The most direct and immediate effects of monetary policy actions, such as changes in the federal funds rate, are on the financial markets. Ben

Bernanke, Former Fed Chair (2006 – 2014)

Monetary policy has a significant impact on interest rates and thereby equity prices. Accommodative monetary policy generally leads to lower interest rates and higher stock prices while restrictive monetary policy has the opposite effect.

When you buy a share of stock, you are purchasing an ownership stake in the underlying company. Your ownership stake represents a claim on the firm’s cash flows, earnings (profits), and dividends. Stock prices reflect the present value of the company’s expected future earnings. Interest rates effect both the present value calculation and the expected amount of future earnings of stocks by impacting the discount rate, the relative value tradeoff against other asset classes, and the amount at which corporations can borrow or refinance. Note that these influences are not mutually exclusive, they happen simultaneously but at different levels depending on company specific factors.

Lower discount rate
The discount rate is the interest rate used to determine the present value of future cash flows. Consider the difference in present value based on the same cash flows but different discount rates:
Note that present value is higher with a lower discount rate (these two variables move inversely to each other). Present value is essentially how much someone would need to invest today, at a certain interest rate, to receive specific future cash flows (i.e., someone would need to invest $471 today at a 2.00% interest rate to receive $100 in each of the next 5 years). To determine the current value of a stock price, an investor can calculate the present value based on an assumed discount rate and estimated cash flows. When the discount rate increases (decreases) the present value of future cash flows become less (more) valuable today.

Note that present value is higher with a lower discount rate (these two variables move inversely to each other). Present value is essentially how much someone would need to invest today, at a certain interest rate, to receive specific future cash flows (i.e., someone would need to invest $471 today at a 2.00% interest rate to receive $100 in each of the next 5 years). To determine the current value of a stock price, an investor can calculate the present value based on an assumed discount rate and estimated cash flows. When the discount rate increases (decreases) the present value of future cash flows become less (more) valuable today.

Relative Value Tradeoff
Successful investing is about maximizing the risk and return tradeoff. Either maximizing return for a defined level of risk or minimizing risk for a given return threshold. This applies both among and across asset classes. Asset allocation investing requires relative value analysis across asset classes to select the optimal mix of stocks, bonds, cash and/or alternatives in a portfolio.

Interest rates impact both the absolute and relative value of all asset classes. For example, an increase in interest rates will not only decrease the present value of stock prices, but it will increase the future expected returns of fixed income investments. Therefore, as rates rise, stocks become less attractive to individuals or institutional investors who require a return above a certain threshold and can then purchase “safer” investments to achieve those targets. The opposite is true when rates decrease. The investment phrase, there is no alternative (TINA) describes an environment where low interest rates effectively force investors into riskier assets to achieve certain returns. To summarize, as interest rates change, investors update their forecasted returns across asset classes and adjust their portfolios accordingly.

Corporate Cash Flow Expectations
As mentioned, stock prices represent the present value of a company’s expected future earnings (all else equal, increased cash flows will lead to high earnings). A change in interest rates will impact cash flows as corporations manage their capital allocation through debt issuance or refinancing. For example, as rates decrease corporations can choose to add leverage by issuing debt to invest in new projects or refinance existing debt to lower their interest expense. Each of these actions will increase cash flows.Accommodative monetary policy increases corporate cash flows, which raises stock prices.

CONCLUSION

Don’t fight the Fed.

Martin Zweig, Market Strategist

The Fed and their monetary policy decisions have a significant impact on the economy and financial markets. Since the Financial Crisis, the Fed has grown even more impactful as they have become more willing to use nontraditional monetary policy tools to boost the economy. During the pandemic, the Fed launched the most accommodative monetary policy environment in United States history by lowering interest rates to effectively zero, restarting their quantitative easing program by purchasing Treasuries and mortgage-backed securities, and launching several new lending facilities. As a result of the Fed’s policies their balance sheet increased to over $8 trillion. The Fed’s policies helped save the economy from a major recession and was the main driver of the stock market boom since March 2020.

Now that the economy is on the path to recovery and inflation pressures are rising, the Fed must decide when to tighten monetary policy by first taking their foot off the gas pedal (tapering the quantitative easing program) and next by hitting the brake (raising interest rates). The Fed’s timeline has accelerated in the last few months as both economic growth and inflation have been higher than previously forecast. Our sense is that the Fed will begin tapering within the next six months and will raise interest rates in late 2022. We also expect that the Fed will telegraph their actions far in advance to try and not upset the financial markets. While the stock market would prefer for the Fed to remain ultra-accommodative, that is a recipe for financial bubbles and inflation, so the Fed must act before either get out of hand. “When will the Fed tighten?” will be one of the most important questions facing financial markets in 2021. The Fed is not ready to hit the brake yet, but they are getting close to easing their foot off the monetary policy gas pedal.

At Winthrop Wealth, monetary policy is a vital component to our market outlook and portfolio positioning. We continue to believe that analyzing the impact of current Fed policy and anticipating the potential implications of future policy are critical to successful portfolio management.

We apply a total net worth approach to both comprehensive financial planning and investment management. Financial planning drives the investment strategy and provides a roadmap to each client’s unique goals and objectives. The com¬prehensive financial plan defines cash flow needs, is stress tested for various market environments, optimizes account structures, considers tax minimization strategies, and continuously evaluates financial risks as circumstances and/or goals change. The invest¬ment management process is designed to provide well-diversified portfolios constructed with a methodology based on prudent risk management, asset allocation, and security selection.

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DISCLOSURES:

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Financial planning is a tool intended to review your current financial situation, investment objectives and goals, and suggest potential planning ideas and concepts that may be of benefit. There is no guarantee that financial planning will help you reach your goals.

Likewise, it is important to remember that no investment strategy assures success or protects against loss. Past performance is no guarantee of future results. Asset allocation does not ensure a profit or protect against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. All investing involves risk which you should be prepared to bear.

Rebalancing a portfolio may cause you to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.