Navigating the Disconnect: The Changing Landscape of Monetary Policy and its Implications for Market Expectations and Equities

In the years leading up to the 2008 financial crisis, the US Federal Reserve operated under a “scarce reserve” monetary policy, which fostered an active marketplace where banks engaged in federal funds trading. However, since the introduction of Quantitative Easing following the crisis, the monetary landscape has undergone a significant transformation. The flood of reserves into the system has severed the direct link between interest rates and the money supply. In this article, we examine the implications of this shift and its impact on market expectations and stock valuations.

Previously, the federal funds rate was determined by an active marketplace of lending and borrowing reserves among banks. This system maintained a direct connection between the money supply and interest rates. However, the Federal Reserve’s response to the 2008 financial panic, through Quantitative Easing, led to an abundance of reserves in the system. Consequently, banks no longer borrow or lend these reserves; instead, the Fed pays them to hold them. This change has severed the direct link between interest rates and the money supply.

Under the current system, the Federal Reserve has the sole authority to set interest rates, resulting in market expectations being heavily influenced by speculation about the Fed’s next moves. Every economic data point now carries weight as investors try to anticipate the Fed’s decisions. Earlier this year, the market priced in multiple rate cuts for the second half of 2023. However, after a robust employment report indicating solid job growth, the odds of a July rate hike surged to almost 90%. We believe the market is underestimating the likelihood of the Federal Reserve raising short-term rates beyond July.

The Federal Reserve closely monitors the labor market and average hourly earnings. Recent reports have shown stronger economic performance than anticipated, accompanied by persistently high global inflation rates. Average hourly earnings rose 0.4% in June and are up 4.4% from a year ago. Despite the Fed’s focus on the labor market due to its models, we argue that the central bank should consider actual inflation and the money supply. Given a 2.0% inflation target and slow productivity growth, the Fed would prefer to see average hourly earnings grow closer to a 3% annual rate rather than the current 4.4%.

The low unemployment rate, which currently stands at 3.6%, compared to the Fed’s projection of 4.1% for the fourth quarter, further strengthens the case for an aggressive stance by the central bank. At its June meeting, twelve out of eighteen Fed policymakers believed that rates would increase at least two more times in 2023. This suggests that unless economic and inflation data significantly deviate from expectations, only one rate hike is unlikely for the remainder of the year. This scenario raises concerns about overvalued equities.

If the Federal Reserve ends up raising rates more aggressively than anticipated, long-term interest rates could face upward pressure in the coming months. Our Capitalized Profits model, which evaluates the fair value of the S&P 500 index based on nationwide profits and the 10-year US Treasury yield, suggests that the index is fairly valued at around 3,350 with a 4.00% 10-year yield. A higher yield would drive the measure of fair value even lower.

We have been monitoring the M2 measure of the money supply, which has experienced its most significant decline since the Great Depression. Although the US economy is still absorbing the effects of the massive money printing during the COVID-19 pandemic, this trend is expected to taper off soon. A decline in M2 is likely to push the economy into a recession in the near future.

Investors currently seem unworried about a potential recession, assuming the Federal Reserve will implement rate cuts to counteract any downturn. However, our model suggests that even with a 3.00% 10-year yield, a 15% decline in profits would significantly impact the fair value of the S&P 500, reducing it to just 3,800. The optimism surrounding a “Goldilocks” scenario, where the Fed perfectly manages all factors, may be too idealistic. In light of this, adopting more defensive strategies may be prudent at this juncture, considering the possibility of overvalued stock prices.