Is the Fed Pivot Coming? What should we do?

Fed Pivot

Fed Pivot means a change in the Fed monetary policy, from tightening to easing, or vice versa. FYI, the Fed is the US Central Bank.

 

Which Fed pivot are we referring to here?

In early 2021, the inflation rate was still at ~2%. However, by the end of 2021, the inflation rate has jumped to >7%. The Fed has been in a loose monetary policy since the COVID-19 pandemic by injecting liquidity into the market. This excess liquidity causes inflation to rise. With such high inflation, the Fed had to pivot into a tightening cycle by hiking the interest rate at a fast pace. Toward the end of 2022, we started to see the inflation rate moderating and the market expecting the bulk of the interest rate hikes to be behind us. We are already at the end of the rate hike cycle. As inflation returns to normal, the Fed will soon pivot back into its loose monetary policy.

 

From the last FOMC meeting

The Fed meets almost every month to discuss the state of the economy and its economic policy. In the Jan 2023 FOMC meeting, the Fed raised the benchmark interest rate by 0.25% to the target rate of 4.5-4.75%.

The market already expected this rate hike. The surprise came during Fed Chairman Jerome Powell’s speech after the meeting. Powell has always been very hawkish in his previous speeches since the Fed started hiking rates. This time, his stance is still the same as before, which is for the Fed to stay on its course until they are sure with high confidence that inflation has been under control and reaching its target inflation rate of 2%. However, at the same time, he also acknowledged that inflation has been moderating, and the Fed’s focus is now on slower rate hikes while waiting for more data to come in. The Fed is now at the tail end of its rate hike cycle. The Fed’s hint about winning the inflation battle was unheard of before, and the market was euphoric. The market believes this is the Fed pre-pivot, and the actual pivot is coming soon. Because the market is forward-looking, the market rallied to price in this pivot.

Before you jump in and buy all those risk-on assets, such as stocks and REITs, it would be better to understand first what possible scenarios that may happen so that we can manage our risk appropriately.

 

The Fed Dual Mandate

The Fed has a dual mandate: maximum employment and price stability.

Maximum employment

How is the Fed doing in this metric? We have heard of the various layoffs impacting many tech firms in the past few months. Many economists are expecting a recession which may cause unemployment to rise. However, the latest job data shows a different picture. The US economy added 517,000 jobs in January, with the unemployment rate at 3.4%, the lowest in several decades. Wage growth is also stable. The job market is vibrant overall, and there is no indication of a looming recession. At least, not yet. The Fed is doing very well on this mandate.

Price stability

Rising inflation causes prices to go up. Though has moderated, inflation is still at an elevated level. High inflation not being dealt with may cause the hyperinflationary loop to happen. Wages rise so people can afford higher prices. But then higher wages allow higher prices to become affordable, and the cycle continues. This loop is called the wage-price spiral. And this spiral causes hyperinflation. The Fed has been working on this mandate by raising the interest rate fast to curb spending and borrowing, thus lowering inflationary pressures. However, more work still needs to be done because inflation is still high above their target rate of 2%.

Based on this dual mandate, the Fed can afford to wait until inflation is firmly under control before pivoting. Powell has more room to keep interest rates high because the job market is still strong.

 

Scenarios of when the Fed pivot will come

We know the Fed will eventually pivot. There is no reason to keep interest rates this high if inflation is already under control. The question is: when will this Fed pivot happen? Let us consider some possible economic scenarios and their respective Fed’s pivot.

Scenario #1: Soft landing

Soft landing fed pivot
There is no recession, and the Fed will slowly lower the interest rate.
  • There is no recession, and inflation goes down by itself naturally. The Fed will likely keep the interest rate high in the short term and gradually lower it afterward.
  • This outcome is the best-case scenario for the economy and the one that the Fed prefers.
  • In this case, the market rally will continue. A new bull market may have formed.

Scenario #2: Hard landing

Hard Landing Fed Pivot
The economy enters a recession, and the Fed will have to lower the interest rate at a fast pace.
  • The economy enters recession because the Fed over-tightens its monetary policy. A recession means inflation will go down while unemployment will rise. In this scenario, the situation flips for the Fed. To do their mandate, the Fed will have to pivot to easing policy to support the now ailing economy.
  • The Fed pivot will happen as soon as the recession comes. The pace of the interest rate decrease will also be fast.
  • If a recession happens, the market may correct again based on the severity of the recession. Note that this correction is not guaranteed because the market usually bottoms ahead of the bottom of the earning recession. Remember, the market is forward-looking. Afterward, the market will likely rise again as the Fed pivots to the loose monetary policy to inject more liquidity into the market.

Scenario #3: Double top inflation

Double top inflation Fed pivot
The inflation declines, and the Fed starts lowering the interest rate prematurely. As a result, inflation rises again, and the Fed has to hike the interest rate even more aggressively.
  • The inflation starts to decline enough in the short term to make the Fed believes they have won the battle. The Fed will pivot here into a loose monetary policy. However, in this scenario, the rate cut is too early. Inflation starts to spike again. The Fed will have to pivot back into the tightening cycle and increase the interest rates again.
  • The market will rally in the short term until the point where inflation spikes again, and the market will crash as the Fed needs to be more aggressive this time to curb the sticky inflation.

Determining the event that triggers the pivot is relatively straightforward for each scenario. But the question is: which of those scenarios is more likely to happen? Nobody knows for sure, not the market, not even the Fed. Only time will tell.

 

What should I do? Should I buy stocks?

First, ask yourself whether you are a short-term trader or a long-term investor.

As short-term traders, you may take positions based on what you think is the more likely scenario and continuously re-evaluate your positions as more data comes in.

As long-term investors, you do not need to guess the scenario correctly.

  • For passive investors, you can dollar-cost-average (DCA) the index. Stay on a consistent course regardless of when the pivot will happen. Focus on the time in the market instead of timing the market.
  • If you are a more active investor, you can DCA into undervalued companies. If your valuation model indicates a company as undervalued, go ahead and buy it. If not undervalued, then pass. Stick with your plan. Note that in a recession, all stocks usually will get hit. This lower valuation during a recession may be a good opportunity for you. You can set aside some cash on the sideline to take advantage of this opportunity should it presents itself.
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Disclaimer: The information provided here is not intended to be and does not constitute financial advice, investment advice, trading advice, or any other advice or recommendation of any sort.

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David Ang

About David Ang

A long-term investor with a portfolio across the United States and Asian equities, REITs, commodities, and fixed incomes. After over a decade of hands-on investing (and making countless mistakes), I'm excited to use this platform to share what I've learned over the years. And let's continue to learn together. Writing about macro economy, equities, personal finance, web3. Follow me on Twitter: @danggaku