The Fed’s Starring Role in the BubbleBy Larry Benedict, editor, Trading With Larry Benedict
The Federal Reserve is fueling investor optimism.
After keeping interest rates on hold since last December, the Fed cut by a quarter point in September and just delivered another one this week.
Market odds favor another cut at the Fed’s last meeting in December… and then two more rate reductions next year.
Investors may be in a frenzy over artificial intelligence headlines and Nvidia’s march to a $5 trillion market value. But the return of the Fed’s easy money policy is playing a key role in boosting stock prices as well.
In doing so, the Fed risks failing one of its key mandates… and it wouldn’t be the first time.
Here’s why the Fed’s rate cuts put your portfolio at risk…
Fueling BubblesEconomists tend to focus on the Fed’s mandates of supporting high employment and low inflation. Those objectives are mandated by a law Congress passed in 1977.
But there’s another mandate that receives less attention… financial stability.
In fact, you could argue that financial stability is the Fed’s original mandate. After all, the central bank’s creation in 1913 sought to prevent outright market panics.
A properly functioning market plays a key role in economic activity. Stability and access to capital are the lifeblood supporting the broader economy. When stability is threatened and the market starts to seize up, bad things happen.
And the Fed has a sketchy past. It has played key roles in inflating the biggest bubbles ever seen… and the busts that followed.
For instance, the Fed cut interest rates in late 1998, which helped drive the internet bubble to new heights.
And in 2003, the Fed cut interest rates to the lowest levels ever seen up to that time. That helped drive reckless speculation in the housing market ahead of 2008’s financial crisis.
Likewise, loose monetary policy after the pandemic played a part in runaway inflation that hit the highest levels since the early 1980s.
We know how each of those episodes ended. And history looks doomed to repeat itself.
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Fueling BustsThe Fed is rejoining the largest global easing campaign since the aftermath of the Great Financial Crisis.
Over the past two years, there have been 312 rate cuts by central banks around the world. That’s nearly surpassed the 313 cuts globally in the two years following the housing bust.
Back then, we needed rate cuts to support a global economy limping from the worst financial crisis since the Great Depression. Nothing like that is going on today, and yet central banks are cutting anyway.
What’s even more shocking is that the Fed knows the risks.
Fed Chair Jerome Powell commented in September that by many measures, asset prices “are fairly highly valued.” That’s putting it mildly. Signs of a bubble are everywhere.
The 10 largest stocks in the S&P 500 now account for a record 40% of the index.
The S&P 500’s price-to-earnings (P/E) ratio (using expected earnings over the coming year) sits at 22.8. That’s approaching the peak seen during the internet bubble.
The technology sector’s P/E ratio currently sits 64% above its 20-year average.
But that isn’t stopping the Fed from pursuing a loose money policy that threatens us with another bubble and subsequent bust.
And the more the Fed helps inflate the bubble, the bigger the eventual downturn.
I know I sound like a broken record at this point.
But the truth is, we’re nearing the edge of a cliff. We don’t know which specific turn will lead the market over. But now is a time when I’d recommend caution and careful risk management.
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict |
