The US Federal Reserve actively wishes to crush stock markets: ignore it at your peril

There is every sign that the Fed actively wishes to crater equity prices in order to restrain demand through the wealth effect. It wishes to push up junk yield spreads and restore some Schumpeterian discipline to corporate finance. It wishes to tighten financial conditions as a mechanism for choking inflation. It is a “tug of war” between the Fed and the markets, says Krishna Guha from Evercore ISI.

The institution is willing to let the dollar index (DXY) vault to a 20-year high and tighten the tourniquet for emerging markets. It intends to accelerate the pace of quantitative tightening (QT) in September with $95bn of monthly bond sales. It intends to drain liquidity from the world’s dollarised financial system, and the rest of us can drop dead. Fight this Fed if you dare.

Bulls retort that US corporate profits have defied dire predictions. Earnings muddled through in the second quarter, although they fell by 4pc (year-on-year) sans energy, and revisions are coming in thick and fast. Factset says most S&P 500 companies that have spoken so far are issuing negative guidance for this quarter.

There is another catch. The next downturn will be different from past episodes. Companies are going to hoard labour to avoid the sort of reopening shortages we have seen since the end of the pandemic. “It’s what we always used to see in Japan in the 1980s and 1990s: consumption holds up better in the recession, but profits take the strain and collapse,” Albert Edwards from Societe Generale.

Furthermore, the equity rebound from mid-June to mid-August – 14pc for the S&P 500, 22pc for the Nasdaq, 7pc for the FTSE 100 – has been fuelled in part by what CrossBorderCapital calls the “Fed’s QT summer lull”.

This was caused by a quirk in the market for mortgage bonds held by the Fed. The effect will be overwhelmed once QT begins in earnest next month. That is when the real trouble begins. The Fed has repeatedly been caught off guard before by the potent effects of bond sales, chiefly because it disregards the quantity of money effect.

The Fed laid out its theory in a paper in June: the house model equates $2.5 trillion of QT to nothing more than two quarter point rate rises. This is contestable in monetary theory and empirically false if you live in the real world of the markets. If the Fed really thinks that $2.5 trillion of QT is little more than background noise, there is going to be blood on Wall Street and world bourses.

In essence, investors have been betting that US inflation has already peaked, that the Fed will soon roll over (whatever it says), and that the US economy remains in rude good health. This glorious combination opens the way for another leg of the bull market.

You can certainly paint such a rosy scenario. The US economy added over half a million jobs in July. If the US has one foot in recession, it is an odd sort of recession.

But be careful. The headline non-farm payrolls figure is a lagging indicator. “It is at odds with a rather impressive list of data. Could it be that payrolls are right and everything else is wrong?” said Tom Porcelli, a former New York Fed official now at RBC Capital.

Measures that catch turning points earlier are ominous. Weekly initial claims – unemployment filings – have been climbing since March. Full-time employment has dropped by 150,000 since then under the “household survey” measure. A string of industrial surveys have been dire. The New York Fed’s manufacturing index (Empire State) has collapsed to 2008 levels.

Yes, inflation is looking better behaved. The headline rate dropped from 9.1pc in June to 8.5pc in July, and was slightly negative on a month-to-month basis. This was not just because of falling oil and commodity prices. Clothing is in deflation too.

But, again, be careful. Inflation may fall too fast for comfort. The US money supply figures have swung from boom to bust. Over the last three months M1 money has contracted in absolute terms, and has been falling at a double-digit annual pace in real terms. If this does not lead to recession this winter, it will be a miracle.

The greatest danger is the behaviour of the Fed itself. The institution seems not to have learned any theoretical lesson from what has gone wrong. It clings to its old model. It persists in ridiculing money data. It is therefore in the process of repeating the mistake it made two years ago when it generated today’s inflation, but this time in the opposite deflationary direction through monetary overkill.

Never overlook the emotional element in central banking. Last year’s gathering at Jackson Hole saw much self-congratulation among the global monetary fraternity. Had they not printed their way through Covid with daring and panache? Had they not saved civilisation?

Mr Powell insisted then that there were no signs of “broad inflationary pressures” and that any jump in prices would prove “transient”. He stressed that inflation expectations remained “anchored” – as indeed they were, further evidence of the uselessness of that monetary lodestar.

A year later, the historical verdict is brutal. The 2021 forum was a humiliating fiasco: the requital for New Keynesian hubris, and the end of the superstar central banker as a Jupiterian deity.

Mr Powell and his colleagues are now on a mission to redeem themselves and prove that they can conquer inflation after all. Zeal is a dangerous thing. That is why I fear the Jackson Hole of 2022.

This article is an extract from The Telegraph’s Economic Intelligence newsletter. Sign up here to get exclusive insight from two of the UK’s leading economic commentators – Ambrose Evans-Pritchard and Jeremy Warner – delivered direct to your inbox every Tuesday.