Two key moves from the Federal Reserve have boosted stocks, but they could come with a price

The stock market has picked up 2020 pretty much where 2019 left off, thanks in large part to two key Federal Reserve moves that could keep the rally going, at least until something goes wrong.

Amid an already strong backdrop for Wall Street, the Fed issued two directives right around the same time in October — one, an open commitment to providing liquidity in the short-term borrowing market for banks, the other a pledge not to increase interest rates until inflation rose substantially higher.

Taken together, the moves have been seen as stimulus that while stealthier than the measures taken to pull the economy out of the financial crisis, nevertheless represent important backing that has been positive for the kind of risks that stocks embody.

“The biggest thing the Fed has done, which is really out of the box, is just this insistence ... that their goal is to raise inflation,” said Jim Paulsen, chief investment strategist at The Leuthold Group. “That‘s a really big message that I can’t think of another Fed really delivering.”

While that message has been seen as unequivocally positive for the market and economic projections in 2020, there is concern about danger further down the line.

Looking for ‘significant’ move

The big moment regarding inflation came in late October when Fed Chairman Jerome Powell said he would need to see a “really significant” move higher before hiking interest rates. The statement came after the central bank had approved its third rate cut of the year and as investors were looking for guidance on what the next move might be.

Since then, Fed officials have underlined the effort to bring inflation up with statements indicating that they might tolerate a level higher than the 2% they‘ve previously targeted as in line with their congressional mandate for price stability. At a time when the market was just getting over fears that a recession was on the horizon, the Fed’s pledge helped soothe some jangled nerves.

“This change in the Fed strategy is extremely significant,” said Steve Friedman, senior macroeconomist at MacKay Shields. “To me, it means they want to see inflation above 2%. This is very supportive of risk assets and economic growth in the year ahead.”

Friedman said the change means the Fed has gone from considering 2% a ceiling for inflation to perhaps a floor. Inflation is associated with rising prices and interest rates, though MacKay Shields expects the Feds moves will result in “somewhat higher” government bond yields though a continued low-rate environment overall.

QE or not QE, it doesnt matter

The other side of the Fed‘s move came from its intervention in the overnight borrowing system, through a process known as “repo” that provides the basic plumbing for the banking industry. The process involves banks’ exchanging high-quality collateral for cash and liquidity from the Fed.

A financial system cash crunch in mid-September briefly sent very short-term rates surging and raised fears that the Fed‘s efforts to reduce the bonds it holds on its balance sheet were sucking reserves out of the system and jeopardizing the repo market’s usually smooth operations.

The Fed since implemented its own repo operations on an as-needed basis, then decided to extend its operations through at least the second quarter of this year.

To some market observers, the move resembles the quantitative easing process the Fed used during and after the crisis to hold rates down and revive the housing market. QE helped boost market prices by providing greater liquidity to the system, but officials insist the nature of these operations is different and geared only toward keeping its benchmark for short-term lending within a range of 1.5%-1.75%.

Still, the increase in the balance sheet through the Fed repo has been in near lockstep with the stock markets rise during the same period. The balance sheet has expanded more than 10% since early September; the S&P 500 is up about 11% since then.

Even if this is not technically another round of easing — QE4, as the markets call it — the impact has been the same.

“In this post-crisis regime of QE-everywhere, people just associate money printing and an expansion of ones balance sheet with an attempt to lift asset prices,” said Peter Boockvar, chief investment officer at Bleakley Advisory Group. “Some of it is not direct. A lot of it is psychological.”

The danger of wanting inflation

The upside from the Feds moves has been a sharp move higher in stocks without a corresponding jump in rates and government bond yields.

The downside, though, is substantial and not inconceivable.

Placing so much emphasis on inflation might finally get the Fed over its 2% hurdle, but once there things could get tricky. If the Fed overshoots, it will have to raise rates, perhaps quickly. Consumers, on whose backs the recovery has largely rested, have enjoyed the low inflation environment and might pull back if things change.

“2020 is going to lay the groundwork for what could be very difficult policy for them in 2021,” said Steve Blitz, chief U.S. economist at TS Lombard. “They‘re going to let it run through the year. Their big challenge is going to be at some point this year, there’s going to be pressure inside the Fed to raise rates.”

The market did not react well to the Feds effort to normalize interest rates. In 2018, when the central bank hiked four times, the S&P 500 fell by more than 6% for its worst performance since the bull market started in mid-2009.

“They can‘t allow the equity market to slip into a bear market. They can’t afford a December 2018 when it went down and stayed down,” Blitz said. “They‘ve so flooded the system with liquidity that market prices can’t return to you any information about market sensitivities and market concerns about the economy.”

Paulsen, the Leuthold strategist, said he sees a 1-in-3 chance of a negative outcome from the quest for inflation, which he noted is at odds with monetary goals through history.

The Fed wants inflation sustained at a decent pace in part because low inflation depresses rates which provide less policy room in the case of a downturn. However, high inflation also poses dangers.

“Where this thing could really take on a reverse impact is if the inflation numbers radically change. The nice feel and support for policy that investors have could really change quickly,” he said. “Imagine the investor of the ‘70s or early ’80s or even ‘90s if they were comatose for a while and woke up and looked at this. They wouldn’t necessarily think of it as a good thing.”