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  • Writer's pictureEng Guan

The Fed Factor: Tracing the Impact of Fed Funds Rate on Financial Markets Since 2001 (Part 2)

In Part 1 of this post which was published earlier, we introduced what Fed Funds rates are and how it has impacted the financial markets from 2001 to 2007. If you have not read Part 1, you can find the post in the link below.



In Part 2 which is also the final part of this series, we continue from where we left off and look at what happened after 2007.


Great Financial Crisis (July 2007 to December 2008)

Following the real estate boom from 2004 to 2007 where subprime mortgages permeated deeply into the financial system, things quickly escalated into massive waves of defaults that brought the value of the CDOs down sharply. Such a scale of default across the nation was not something planned for. Even the safest tranche of the CDO or the so-called investment grade equivalent is not spared. These once highly sought-after CDOs soon became toxic assets that everyone wanted to get rid of but no buyers wanted to take them in.


The real estate market collapsed. Funds bite the dust. Banks and financial institutions announced wave after wave of write-downs and the system was brought near the brink of collapse as confidence plummeted. Bear Stearns and Lehman Brothers ended up as casualties. The high leverage that was built up in the system was unwound and caused an extensive market fallout and a severe recession that was not seen since the Great Depression in the 1920s.


During the turmoil, the Fed had to cut rates aggressively bringing them down to near zero, and work with the US government to bail out the financial institutions. Quantitative easing (QE) was also launched to flood the system with money where the Fed buys longer-term securities such as Treasuries and mortgage-backed securities. The intention is to let this money find its way into stimulating growth and accelerate recovery. But we now know that didn't happen for a long long time. Unlike fiscal policy which can target where you want the money to go, monetary policy is a blunt tool. The money pumped into the system failed to reach the hands of the masses. What it did instead was just to depress the interest rates and push up asset prices in the many years that followed.


Asset Class Performance During Great Financial Crisis

In any case, from 2007 to 2008 at the height of the crisis, all risky assets fall, including high yields. And this time around, people don’t see REITs as safe havens. Everyone was running from anything related to real estate. Funds flow to the traditional safe havens bonds and gold. 


Post-Great Financial Crisis (December 2008 to December 2015)

Fed Funds During Post GFC

The Fed conducted 3 rounds of QE with the last one ending in 2014. Yields fell to new lows. 20Y yields went below 3%. Yet, for much of this period, growth was muted and inflation remained subdued. The tons of money that the Fed flushed into the system failed to ignite the economic engine to levels they had hoped for. Instead, this excess money found its way into pushing up risky asset prices such as stocks, real estate, and high yields. And bond prices also rose thanks to the massive bond-buying QE programs from the Fed. It was a prolonged regime where almost every asset class rose. The only exception was commodities which reflected the real economic activity and situation.  


Asset Class Performance During Post GFC

Post-GFC Normalization Hike (December 2015 to November 2019)

Fed Funds During Post GFC Normalization Hike

In 2015, the Fed started its first hiking cycle since the end of the GFC even though the core inflation was still operating under 2% then. The intention is to normalize the rates which have been artificially depressed for an extended time because of QE.


Even though the fed funds rates were brought above 2%, the long-term rates did not follow and remained close to their lows. As a result, bond prices also rose. This, however, is not as unexpected as the market could be due to bond players pricing in a slowdown and falling long-term inflation. But that aside, the hike wasn’t excessive and started from a low base of practically zero. Money from all the rounds of QE is still in the system, Fed has not withdrawn any liquidity. So, the rest of the markets pretty much continue to advance.


Asset Class Performance During Post GFC Normalization Hike

Mid-Cycle Adjustment & Covid-19 (November 2019 to April 2020)

Fed Funds Rate During Mid-Cycle Adjustment & Covid-19

In late 2019, the Fed under Jerome Powell initiated a short cycle to cut the Fed Funds rate. They positioned it as a mid-cycle adjustment as the economy is showing signs of buckling under the tensions of the US-China trade war. The cuts were brief and modest but there isn’t much left to cut anyway.


Then just shortly after they paused, COVID-19 spread and panic ensued. Countries implemented lockdowns and travel restrictions. Businesses were forced to shut and people had to stay indoors. The supply chain and logistics were severely disrupted and there were massive layoffs. This hit the economy severely. The Fed cut rates instantly down to zero and implemented the ultimate QE or “QE Unlimited” declaring they will do whatever it takes to restore things to normal.


During that period, risky assets plunged but recovered much of the losses rapidly by April 2020. Treasuries and gold on the other hand surged as investors moved their funds into safe havens.


Asset Class Performance During Mid-Cycle Adjustment & Covid-19

Post Covid-19 Recovery & The Soaring Inflation (April 2020 to February 2022)

Asset Class Performance During Post Covid-19 Recovery

Fed maintained its supportive policy during this period. But in 2021, inflation picks up rapidly as nations reopen. Businesses and pent-up demand also came roaring back. However, the disruptions brought about by Covid-19 had gravely disrupted the supply chain and created serious bottlenecks that led to a severe demand-supply imbalance. As a result, commodity prices jumped. To meet the demand, companies also hired aggressively competing with each other leading to spiraling wages. All these raised the costs for businesses which are ultimately passed down to consumers. 


The markets, in particular bond players, were already voicing concerns about the soaring inflation. Fed however brushed it aside. Their initial assessment was that inflation was something transitory and would subside quickly once the global economies returned to normal functioning levels. That, however, did not materialize as fast as the Fed hopes. Inflation shoots through the roof with headline inflation breaking past 9% and core reaching a peak of about 7% in early 2022.  


During this period, risky assets are still enjoying a good time riding on the back of a recovery from COVID-19 where the economy is picking up speed as businesses open up and more and more people return to the workforce. Commodities practically flew in this short period because of the imbalances created by the supply chain bottlenecks. Bonds are the only ones that fell, showing the warning signs as yields rose.


Asset Class Performance

 

Post Covid-19 Recovery & The Soaring Inflation (April 2020 to February 2022)


Fed finally admitted they were wrong about the inflation and went on a hiking rampage that brought the Fed funds rate from near zero back to the pre-GFC levels. In June 2022, they also started quantitative tightening to reduce the liquidity in the market.


There was a period where inflation was still ramping up furiously while the Fed was hiking and talks about a possible stagflationary regime like those in the 70s surfaced. Fortunately, core Inflation did abate eventually as the supply-demand imbalance loosened and the heightened rates started to work their way into the economy. But as it is, the core inflation is still way above their threshold of 2%.


This is an exceptionally tough period for the financial markets which suffered tremendously under the twin pressures of increasing inflation and interest rates. But towards the end of this hiking cycle, markets start to recover quickly. Stocks erased all their losses before the cycle even ended. Bonds, however, are still underwater because rates are now significantly higher than it was before the hike.


Concluding Remarks


I am just going to reiterate what I said before in Part 1. The financial markets are complex and highly interconnected. Asset class behavior is never shaped by a single factor such as what the Federal Reserve does. If it is, then it would have made predictions a lot more easier and reliable and we wouldn't see as many anomalies. That is why our approach does not depend on predicting what is coming up next. Our fundamental approach to tackle an ever-changing financial landscape and regimes is to run a well-diversified portfolio comprising different assets and strategies that can adapt to the market environment. To sum it up - Adapt not predict.


 

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