The Impacts Of Federal Reserve Policies On The Economy And Financial Markets
Understanding where we are in the credit cycle and how the Fed impacts its beginning and end is key to improving one’s investment and trading results.
Article by Ayesha Tariq and Markets and Mayhem.
The Federal Reserve has effectively replaced the economic cycle with something vaguely reminiscent, but quite different, which is called the credit cycle. This credit cycle is both created and destroyed by Fed policy changes. Thus, it is a pivotal phenomenon to not only learn about, but also to follow as it unfolds. There are entire investment practices, such as full cycle investing, as well as trading strategies such as macro-driven systematic swing trading, that are built around the credit cycle.
Let’s dive into the credit cycle (as visualized above), and discuss why the Fed is so important to understanding how it functions. When the Fed pivots to dovishness, cutting rates and in recent credit cycles engaging in quantitative easing (QE), we see one of two scenarios emerge:
1: An extension of the current credit cycle, as was the case in the summer of 2019 when the Fed pivoted, as well as March of 2020 when the Fed flooded the global financial system with liquidity.
2: The creation of a new credit cycle, where there was a deep enough recessive environment and bear market in various assets that there was some degree of a reset.
Fed Policy And Credit Cycles
Credit cycles have an outsized impact on both the economy and financial markets. Typically with credit and equity markets leading the way, and the economy following. Part of this buffer effect has to do with the delayed impact of Fed policy on the economy vs financial markets. The reason for this is that Fed policy’s transmission mechanism is directly into financial markets, thus impacts are realized much more immediately there.
The credit cycle begins as financial conditions are eased. Corporations, consumers, and governments are able to borrow more and at lower costs, thus providing a lubricant to the engine of economic growth, which then often follows. Employees are hired, production increases and we see the GDP reflect increasing underlying strength.
Furthermore, with the low rates of interest, banks are hard pressed to find higher yields. This results in lenders making riskier loans and investments fueling growth in low grade credits, creating potential vulnerabilities as rates rise.
Eventually this growth, more generous lending, and the abundance of liquidity begin to become problematic as it leads to asset bubbles and even inflation. It becomes the classic case of too much money chasing too few goods, services, and assets. This is especially problematic in the current credit cycle as we are dealing with a combination of high demand and constraints across the supply chain.
It’s important to note that banks tend to borrow on the short end of the yield curve, leverage up and lend against the long end. As the yield curve begins to flatten, this causes banks to be more selective with lending, as well as compression of margins on those same loans. In turn, this has a negative impact on profitability as there is a lower volume of less profitable loans on the books. The lower volume of lending occurring at higher rates creates additional pressure on economic growth.
As loose monetary policy foments asset bubbles, poor risk management, inflationary pressure, and other undesirable impacts, the Fed pulls back support for the economy and financial markets and the credit cycle begins to end.
When the credit cycle approaches its inevitable conclusion, we begin to see pressure increase first against the financial system, and then the economy itself. Much of the time Fed policy has a lead time of about 6-18 months before it has tangible economic impacts.
How The Credit Cycle Affects The Economy
Such Economic Impacts May Be Felt Across Businesses, Governments, And Households:
As rates start to increase, asset valuations begin to fall. Asset valuations are inherently a function of interest rates and have an inverse relationship with them. Assets that are bought with leverage then start to get called because their values may drop faster than the outstanding loan amount, leading to accelerated defaults.
Businesses have to contend with a higher cost of capital, which may have one or more of a number of impacts, including passing on increased costs, laying off personnel, idling or shuttering operations, or even going out of business completely.
Governments incur a higher borrowing cost as well, which may impair budgetary elasticity and as a result constrain fiscal spending, leading to less support for the economy.
Households, when confronted with a higher cost of capital, are likely to restrain consumption across several key areas of the economy, to include housing, vehicle purchases, discretionary spending, as well as areas like travel and leisure.
The combination of these three pillars of contracting economy, where the consumer represents a whopping 67% of US economic activity, is quite significant. Yet, because the policy impacts can take so long to be realized, it’s not uncommon for the Fed to overshoot in their tightening, thus exacerbating problematic outcomes.
These impacts also create a bit of a negative feedback loop. One example is that consumers lessening spending means less revenue for businesses, which means less hiring, which in turn means less tax receipts for the government.
Conclusion
The Federal Reserve’s policy decisions exert an outsize influence on both global financial markets as well as the economy. Loosening, via lower rates and even QE, leads to easier financial conditions, which in turn stimulates risk appetites for debt, equities, and other more speculative vehicles such as crypto tokens.
Eventually the lower cost of capital and appreciating asset prices also impact the economy as a whole, boosting growth by allowing cheaper and more abundant capital. Healthier risk appetites also cause more investment in earlier stage companies that are often viewed as ‘long duration risk assets.’ This increased availability of capital at a lower cost in turn leads to an increase in economic activity from businesses, consumers, and governments alike.
Often it is the case that the Fed’s policies overshoot both ways: easing and tightening. Part of this may be because there is such a long time lag between the policies being effectuated and their results being realized in the economy. As a result it is difficult to calibrate policy in the near-term because the impacts have yet to be well understood at that moment.
At this point the Fed has increased the Fed Funds rate by 0.75% and is possibly looking to increase rates by an additional 1.00% during 2022. This pace of rate increases is steep and coupled with Quantitative Tightening at the $95B per month, the nominal rates in the economy are set to increase by a magnitude not experienced in over 30 years.
There’s no doubt that the Fed’s current plan seems like they will overshoot this time around as well, as was the case in the 2017 to 2019 tightening cycle. Quantitative Tightening has never been successfully implemented and even the previous attempt was made with a much smaller balance sheet. The Fed managed to reduce exposure by $650B, but at a much more gradual rate. This time around they plan to reduce $1T within a year.
This restriction in the abundance of liquidity and rising rates has a delayed real world economic impact of slowing economic growth, rising unemployment, and a piercing of asset bubbles that formed during loose monetary conditions. The markets tend to see an impact first, usually with increasing default rates, a large correction or even a bear market decline across equities, and impact on other peripheral markets like real estate.
The real world impact from tightening monetary conditions often leads to a recessionary economic environment, where growth stalls from companies closing, consumers slowing down spending, unemployment rising, and other compounding factors. As a result, the Fed tends to step in and reset the credit cycle to its beginning again, loosening monetary policy and repeating the aforementioned processes both in the financial markets and economy.
In closing, understanding where we are in the credit cycle and how the Fed impacts its beginning and end is key to improving one’s investment and trading results.