A Fed pivot refers to a significant policy shift by the U.S. Federal Reserve (Fed), the central bank of the United States, in response to economic conditions. This change might involve moving from a tight monetary policy—raising interest rates to control inflation—to a loose one—lowering rates to stimulate economic growth, or vice versa. Such a pivot is a crucial event for investors, as it can dramatically impact the financial markets, both domestically and globally. In this context, the possibility of a Fed pivot arises from concerns about the health of the US economy, as evidenced by two consecutive quarters of negative GDP growth and declining PMIs. The potential implications of a Fed pivot are manifold, affecting everything from global economic conditions and interest rates to inflation and individual investment portfolios. Hence, understanding this concept and its consequences is imperative for anyone involved in financial markets.
Contents: What is a Fed Pivot?
- Historical perspective: previous Fed pivots
- What are the chances for a Fed pivot?
- Implications of a Fed pivot on the global economy
- Fed pivot sceptics
- How a Fed pivot could affect interest rates
- Fed pivot could be close
- Would the stock market crash?
- The relationship between Fed pivot and inflation
- How to prepare your portfolio for a Fed pivot
Historical perspective: previous Fed pivots
The Federal Reserve (Fed) has historically used the tool of pivoting, or changing the direction of its policy, to control inflation and unemployment. Pivots have often been used in response to significant economic events, such as recessions or periods of high inflation.
- In the late 1970s, the Fed changed its policy stance from easy to tight money to combat inflation. This pivot led to a brief recession in the early 1980s, followed by an economic boom.
- In 2001, following the dot-com bubble burst, the Fed quickly shifted from an inflation-fighting stance to a more accommodative policy to support the economy. This pivot helped the US economy to recover.
- During the 2008 financial crisis, the Fed made a significant pivot, implementing a series of unconventional policy measures, such as quantitative easing and near-zero interest rates, to stabilize the economy.
Each pivot has different impacts on the economy, depending on the specific circumstances at the time. The effects may also take time to become apparent, as policy changes work their way through the economy.
What are the chances for a Fed pivot?
Fed Chair Jerome Powell put an end to any hopes that the central bank would step back from its policy tightening anytime soon during the Jackson Hole meeting, as he reaffirmed his « unconditional » commitment to tackling high inflation.
Today’s environment differs considerably from what we were used to seeing in the recent past. Headline CPI running at 8.5% year-over-year, consumer spending remaining resilient, and especially the unemployment rate near multi-decade lows, give the Fed little reason to prematurely announce the end of the battle against inflation, even if some indicators suggest we are past peak inflation.
Implications of a Fed pivot on the global economy
A Fed pivot can have significant implications for the global economy. Given the size and global integration of the US economy, changes in US monetary policy can create ripple effects around the world.
- For instance, if the Fed raises interest rates, it can lead to a stronger US dollar. This, in turn, can affect international trade, as a stronger dollar makes US exports more expensive and imports cheaper. It may also cause capital to flow out of emerging markets and into the US, as investors seek higher returns.
- On the other hand, a lowering of interest rates by the Fed can stimulate global growth by making it cheaper to borrow and invest. However, it can also lead to inflationary pressures and potentially asset bubbles if left unchecked.
In short, a Fed pivot can have far-reaching effects that extend beyond the US borders, and the global economy needs to adjust accordingly.
Fed pivot sceptics
Some observers believe the central bank is determined not to repeat its mistake from the 1970’s — in which the Fed made errors by easing policy prematurely to shore up growth but before inflation had moderated sufficiently.
This has led traders to shift their bets. Fed funds futures are now pricing in 100 basis points of further tightening across the next two meetings (September and November) with a further 25 bps hike fully priced in for early 2023. Looking further out, a 25bps rate cut is expected only near year-end in 2023.
How a Fed pivot could affect interest rates
The Fed's policy pivot can directly impact interest rates. When the Fed tightens monetary policy, it will raise the federal funds rate, which influences interest rates on everything from mortgages to car loans and credit cards. Conversely, an easing pivot will lower the federal funds rate, reducing borrowing costs.
Fed pivot could be close
However, there are some who argue the Fed does not need a return to 2% inflation to back off. What the Fed wants to see is prices forming a downward trend and inflation expectations remaining stable. To many, such an outcome is a plausible scenario a few months down the road.
For instance, the apparent rollover in oil prices is set to help ease some inflationary pressures, in particular as Brent crude typically has a strong correlation with headline CPI. Moreover, the broader pullback in commodity prices and supply chain inflationary pressures too could be interpreted as an indicator of softening demand, bringing relief to inflation pressures.
It is important to highlight that predicting accurately what will happen in the future is a complicated task. For instance, in 2015-2016, the Fed hiked only once against four expected hikes, effectively a net « loosening » of 75 bps relative to market pricing and expectations.
Would the stock market crash?
The possibility of recession has made it difficult for investors to be optimistic about the markets’ path in the coming months. Nevertheless, most of the bad news is mostly already baked in for stocks. And while Powell’s Jackson Hole speech caught some market participants by surprise, the bond market’s reaction was less meaningful; Treasuries slid but recovered in the following sessions.
Despite the current challenges, the majority of corporate earnings continue to surprise to the upside, and management guidance remains conservative, giving stock markets room to advance. In the US, even if volatility persists, the growth is still holding up, and earnings have remained surprisingly resilient for companies with pricing power. In Europe, the situation is more complex. With high and still-rising inflation mainly due to energy prices, which central banks have little control over, risks of a hard landing (recession) are high.
The relationship between Fed pivot and inflation
There is a strong link between the Fed's policy pivot and inflation. When the Fed pivots towards a tightening policy, it aims to slow down the economy and reduce inflationary pressures. Conversely, an easing pivot is often used to stimulate the economy, which can increase inflation if the economy overheats.
How to prepare your portfolio for a Fed pivot
Investors can take several measures to prepare their portfolios for a Fed pivot. These include diversifying their investments, rebalancing their portfolio regularly, and considering alternative investments such as gold or real estate.
Investors are preparing for a longer period of high-interest rates after the US central bank Chair vowed to ensure elevated prices do not become entrenched. With the S&P500 currently down 17% for the year, stocks appear to have already priced in a mild recession—but not a deep one. The great unknown is how much the economy will actually slow in the near term and at what point the Fed acknowledges that. For the market, we believe that stocks could move higher going into the next year, though not without corrections.