The U.S. Federal Reserve Bank, called by its colloquial name “the Fed” even on its website, made its informal but landmark policy change official last week. For the foreseeable future, the Fed will keep interest rates near zero, focusing almost exclusively on employment.
With its immense financial arsenal, the Fed, as our central bank, has the ability to exert market-bending pressure. The simple yet proven maxim “don’t fight the Fed” has provided a useful guide to investors. This maxim applies to local markets around the world. The highly successful investor Jim Rogers, in his book Investment Biker, a fascinating story about his circle-the-world motorcycle ride to find new ideas, echoed this when he said the first question he asked before investing in a country was, “What is the central bank doing?”
Founded in 1913, the Fed has served as a lender of last resort to help stave off financial panics, which had occurred somewhat frequently. In 1893 and 1907, for example, J.P. Morgan himself stepped in to rescue collapsing markets.
In its 107-year history, the Fed’s priorities have evolved to reflect changes in the economy. Prior to World War II, its role generally remained limited to maintaining financial market stability and preserving the value of the dollar. With the arrival of the war, the Fed’s policy shifted to help keep interest rates low to facilitate the government’s war borrowings. In the decades after the war, the Fed’s primary objective was to keep inflation tamped down – occasionally raising interest rates to “remove the punch bowl just as the party was getting started.” Not fighting the Fed proved to be a healthy investment strategy.
As global growth rates slowed, the Fed’s policy migrated toward helping bolster domestic employment. In 1977, Congress made this official when it established the often-mentioned dual mandate to promote “maximize employment (and) stable prices.” The Fed’s market-crushing but extremely successful campaign to lasso inflation in the late 1970s helped usher in decades of rising employment.
“Don’t Fight the Fed” Proving True Again
The 2020 pandemic, however, has weighed heavily on already-weak secular U.S. and global growth. For investors, not “fighting the Fed” again has proven to be a useful strategy. The Fed’s extremely aggressive efforts in March to support capital markets (combined with gargantuan government stimulus packages) triggered the stunning rally in nearly all asset prices.
The key message is that the Fed cares little about inflation anymore, and instead is almost exclusively focused on maximizing employment. Interest rates will be kept near zero for the indefinite future. Not fighting the Fed suggests a continued surge in stock prices.
But, as it seemingly always does, the “not fighting the Fed” strategy will eventually over-extend itself and then unravel. No one knows when that point will arrive. Easy money in the late 1960s led to the grinding 1970s bear market. Excessive liquidity in the late 1990s spawned the collapse of tech stocks starting in 2000, just as easy money (then rising interest rates in 2005-2007) sparked the market’s collapse in 2008-09. Today, essentially free money has lifted share prices to new records but has also sowed the seeds for the next bear market.
We think the Fed will remain focused on employment until other problems catch its attention. The weakening dollar, early signs of inflation, political pressure to further expand its mandate – any one of these or a myriad of other issues could once again destabilize the currently momentum-driven markets, or at a minimum produce a change in which sectors the market favors. Focusing on stocks that are already out of favor should help investors preserve and build their portfolios.
Editor’s Note: This post was excerpted from the most recent issue of Cabot Undervalued Stocks Advisor. To read the rest of it, click here.