Fed and hall of mirrors - TopAsiaFX

014, Dec 2021

According to economic theory, monetary policy is the key driver of asset price changes. Monetary expansion results in a decrease of the bond market’s rates.  Capital raising costs drop, profitability grows. Positive corporate reports raise stock quotes.

On the contrary, monetary restriction worsens companies’ financial results because of higher borrowing costs. In the real world, it often happens that it’s Fed that follows stock indexes and not the contrary. In 2004, former Fed Chair Ben Bernanke called the interaction between S&P 500 and the Central bank “hall of mirrors”.

Should prisoners be allowed to take control over a prison? The stock market must follow the Fed. Otherwise, the “don’t play against the Fed” principle would make no sense. Still, the markets work the best when market participants are under healthy fear of loss.

People’s wisdom remains something to consider while FOMC officials are ordinary people who make mistakes. It is believed that stock indexes reflect the state of national economies. If so, the Fed’s officials tend to observe their signals and compare them with their own views. 

If their views are different from the market’s opinion, the Committee has two ways to go, each of which implies problems. Adjusting monetary policy to S&P 500’s signals increases a risk of macroeconomic instability in future. Playing against the market increases economic turbulence.

The Fed has tried both ways.  Jerome Powell and his colleagues dropped the federal funds rate by 150 base points in March 2020 in response to the fastest ever stock market decline. Also, they declared that treasuries and mortgage-backed securities would be bought in unlimited amounts.

In December 2018, the Fed chairman said the current rate was far from being neutral. It resulted in a large stock market sell-off. The right communication saved the situation at the beginning of 2019: Powell corrected himself and emphasized the FOMC’s intention to take a pause. That allowed S&P 500 to claw back losses.    

Ben Bernanke would mention the need to communicate with markets too. It was his way of solving disagreements between market signals and FOMC views. Communication is fundamental to the concept of “hall of mirrors” and allows for drawing a parallel with a psychological pathology, when a patient feels a vigorous desire to talk to his/her own reflection. 

The Fed’s and financial markets’ views often coincided as well. Jerome Powell gave up the idea of further normalization of monetary policy in 2019, because the yield curve pointed to an upcoming recession. Back then, it was hard to imagine something that could harm the USA’s solid economy. The answer is now obvious: coronavirus. 

What is the best way of profiting from the hall of mirrors? Finding mistakes in the Fed’s statements. For example, Powell asserted in early spring that the States would see a V-shape recovery. Together with a large monetary stimulus, that assertion allowed S&P 500 to grow 28% from the levels of March’s trough. Today, this assertion looks questionable while a change in the Fed’s views could lead to taking profits on US stocks. Continue reading in LiteFinance.