How the US Fed is driving the stock market crash

There could be a significant turnaround in investor sentiment if the central bank backs away from aggressive monetary tightening, experts say

Traders watch at the New York Stock Exchange as Federal Reserve chairman Jerome Powell announces a rate change. AP

If you asked private investors what triggered this year’s stock market meltdown, most would probably name the war in Ukraine.

The possibility of the conflict with Russia causing a global catastrophe has hammered sentiment, but it’s not the prime cause of the crash.

Others may point to rampant inflation, triggered by this year’s energy shock and post-Covid supply shortages. It’s not that either.

China’s ongoing pandemic lockdowns haven’t helped, but the number one threat hanging over markets is none of the above.

It’s the US Federal Reserve.

The Fed is the main reason why markets and investors are running scared and the recovery won’t come until chairman Jerome Powell changes his hawkish tune.

When he turns dovish, markets will fly again. Some reckon that day isn’t far away and investors should be ready for it.

There’s an old saying that bull markets don’t die of old age, but are killed by the Federal Reserve. That has certainly been the case this year.

The Fed could have saved markets from Russian President Vladimir Putin, just as it saved them from the global financial crisis in 2008-2009 and the pandemic in March 2020.

All it needed to do was give them yet another blast of cheap money in the shape of near-zero interest rates and yet more quantitative easing.

And it would almost certainly have done so, if it wasn’t for inflation.

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Watch: US Fed chief warns of 'pain' in reducing inflation

Instead of bailing out the US economy, as it has done for the past 25 years or so, the Fed is actively aiming to smash a hole in the bottom by engineering a recession to stop prices from raging out of control.

It has reversed decades of monetary loosening by increasing the Fed funds rate from 0.25 per cent to 3.25 per cent in eight months, and shifted from QE to QT. Quantitative tightening is now shrinking the Fed’s balance sheet by $85 billion a month.

This is draining the global economy of liquidity, causing that crash we see around us.

Fed tightening has caused “havoc” and sent investors running for cover, says David Morrison, senior market analyst at Trade Nation.

There are few safe havens as Mr Powell gets belatedly tough on inflation.

“The S&P 500 has fallen up to 27 per cent this year, while many bond investors are down 40 per cent. Even traditional inflation hedges, like gold, have failed to shine,” Mr Morrison says.

Markets anticipate more tightening to come, pricing in “a near 100 per cent probability of another 75 basis-point rate increase to the Fed funds rate at this week’s meeting, which would lift it to 4 per cent”.

Yet, there are growing hopes that Mr Powell may soon strike a more dovish note, Mr Morrison says.

“Just a month ago, analysts were anticipating another 75 basis-point hike in December, but they have now dialled down this forecast. Given that rate hikes act with a lag, it makes sense to slow things down to avoid a deep recession,” he adds.

The Fed’s meeting on Tuesday and Wednesday this week could be pivotal.

“If the Fed signals, either in its statement or in Mr Powell’s subsequent press conference, that it’s preparing to back away from an overly aggressive programme of monetary tightening, we could see a significant market turnaround as we approach year-end,” according to Mr Morrison.

Jeremy Batstone-Carr, European strategist at Raymond Williams, also sees grounds for optimism.

While “in the very near term, base rates are going higher for sure, a de-escalation in the tightening process may not be too far away”, he says.

Investors have priced in a host of challenges, including tensions over Taiwan, Covid restrictions in China, UK and European political and economic disarray, and the collapsing Japanese yen, but Mr Batstone-Carr says they have missed something.

“What has not been discounted is the likelihood that the eventual outcomes from the array of crises befalling the planet in 2022 may conclude constructively.”

He suspects a recession, expected late 2022-2023, may prove short and shallow, and successfully reduce inflationary pressures.

“This, in turn, will likely cause the rate hiking process to peak, at which point markets will focus squarely on monetary policy easing. With the challenges of 2022 in the rear-view mirror, the happy issue for investors will likely be how best to position portfolios for a more constructive future.”

This year’s global equity weakness has “taken much of the froth out of absolute valuation metrics” and laid the groundwork for a more constructive 2023, Mr Batstone-Carr adds.

The money supply is shrinking fast, suggesting that the Fed is winning its inflation fight, according to Giles Coghlan, chief market analyst at HYCM.

“As such, ahead of a possible hiking rate cycle slowdown, investors might consider a more bullish approach to the stock markets,” Mr Coghlan says.

“If the risks that have been weighing on stocks, such as central bank action and rising energy costs, begin to subside, today’s cheap stock valuations will become increasingly attractive.”

Central banks outside the US are already easing, with the Reserve Bank of Australia and the Bank of Canada lifting rates by 0.25 per cent and 50 basis points, respectively, in October.

That was more dovish than markets expected and offers bulls grounds for optimism, says Joshua Mahony, senior market analyst at online trading platform IG.

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Watch: why is everything so expensive right now?

Do not get carried away, though.

“We haven’t hit peak rates yet and a stubbornly high level of inflation could quell this near-term optimism,” he says.

John Wyn-Evans, head of investment strategy at Investec Wealth & Investment, is also concerned that investors could jump too soon, encouraged by recent “dovish surprises” from Australia and Canada.

As ever, it will be the Fed that will define the next leg of the financial market cycle.

“There is increasing chatter that it will consider when and how to slow the pace of increases, but this is far from the pivot that traders crave.”

Mr Wyn-Evans believes the Fed will only ease once activity and inflation are much weaker than today.

“The effects of the policy tightening that has already taken place will take a while to feed through to data and corporate earnings, and so there could be a drawn-out battle between the prospect of a rate-cycle peak and earnings downgrades.”

Investec is preparing for the big shift, starting to close its position of being “underweight” on equities.

“But we need more visibility on both corporate profits and the timing of the rate cycle to contemplate being outright bullish,” Mr Wyn-Evans says.

There is another old investor saying — you can’t fight the Fed. Investors shouldn’t even try. But they should watch it closely.

The Fed can kill any market rally, as we saw in the summer. It will also fire the starting pistol on the next one.

Just not yet.