Long Rally in US Equities Despite Massive Fed Tightening
In the most recent tightening cycle, the Fed has hiked rates by the most since the 1980’s Volcker period and continues to taper its balance sheet. Typically, this much tightening would result in a bear equity market and economic recession – but we continue to see a bull market. In this piece we recap recent market action and the key drivers behind the recent US equities rally.
When the Fed started its recent tightening cycle, US equities fell in 2022 but bottomed out by the second half of the year. Tightening slowed, but without any direct signs of easing, and equities sustained a long rally through 2023, now up +35% from Dec ‘22.
Brief Recap of US Equity Market Action:
1. US equities preempted Fed tightening as markets fell on rate hike expectations. The Fed then followed through by raising rates (25 bps on Mar ‘22) and shrinking its balance sheet (Quantitative Tightening or “QT” starting May ‘22). This played out as expected.
2. US equities bottomed out second half of 2022, beginning to rally in 2023 as the Fed slowed rate hikes (50 bps hike in Dec ‘22 vs. 75 bps hike in Sept ’22) and the market expected the Fed to pause hikes soon. A brief bout of regional bank distress in Mar ‘23 put a small blip in stocks, but the rally continued after. This rally felt premature, and equities seemed poised for correction.
3. Fed delivers final rate increase in Jul ’23 while continuing to taper its balance sheet. Typically, tightening flows through at a lag. With the large magnitude of tightening required to dampen high and rising inflation, you’d expect a bigger dent to markets. Equities briefly faltered Aug – Oct ‘23 (roughly -10% correction), then entered another strong upswing.
While Some Stocks have Soared, the Equities Rally Has Been Broad-Based
Unsurprisingly, semiconductor stocks have stolen the show. Big tech too.
Following the explosion of the AI tech theme in 2023, semiconductor industry stocks have more than doubled, with an acceleration since Nov ’23.
Big tech stocks (“Magnificent 7”: Apple, Amazon, Google, Meta, Microsoft, Nvidia, Tesla) also rallied +50% through the first half of 2023 but fell flat thereafter as gains continued mainly in Nvidia (semiconductor stock).
Somewhat surprisingly, other US Equities have also rallied a lot since Nov ’23.
Even if you take out the two sectors that have rallied the most – semiconductor related (~10% of S&P 500 by market cap) and big tech (~30% of S&P 500 by market cap) – the rest of US stocks are also up +25% since Nov ’23. The recent rally has been more broad-based.
US Equities Rally Supported by Market Expectations of Fed Easing and Ample Dollar Liquidity
Standing in July, monetary policy was still relatively hawkish – the Fed had just finished hiking rates, core PCE YoY (favorite inflation gauge of the Fed) was still above 4%, and overall US economic conditions were strong. However, core PCE YoY quickly dropped to under 3.5% by Oct ’23.
Despite a strong economy and no need to ease (yet), the quick drop in inflation meant the Fed’s hands were no longer tied by their mandate to rein in inflation. Rates markets started preemptively pricing in easier Fed policy – before the Fed even said it was ready to ease – which you can see below in the fall of the UST yield curve from Jul ’23 to Jan ’24. Despite no easing in the policy rate (3-mo rate remained at 5.5%), actual borrowing costs fell between the 6-month to 3-year range. The lower discount rate directly supported equities prices, while lower short-term borrowing costs supported US liquidity.
However, interest rates aren’t the only important driver of dollar liquidity – modern monetary policy tools have expanded over the last 15 years to include a powerful arsenal of other liquidity tools to address the low interest rate environment, such as: QE/QT (direct purchases or sales of financial assets by the central bank), coordination of monetary policy with strong fiscal policy, and other macroprudential policies.
This broader set of actions dictates the amount of effective dollar liquidity in the financial system – liquidity that can go into equities markets. The complex combination of tools has made it more important than ever to understand aggregate USD liquidity, in addition to interest rates, to track the impact on US equities.
Our measure of overall USD liquidity shows that after a brief spike to support regional banks in the spring of 2023, USD liquidity flatlined for many months before an uptick in late 2023. This liquidity supported the recent equities rally.
Ample Dollar Liquidity Flows Through to Domestic Stock Purchases
More liquidity means more idle capital, in places like money market funds, that can move into financial assets like equities.
When there is ample liquidity, domestic investors are more likely to move their money from deposit accounts and money market funds into equities mutual funds, which creates positive marginal buy pressure for equities. That flow has more recently tapered off.
Foreigners Buy Upward US Equities Momentum
Foreign flows are also an important pressure on prices. While this data is less timely, we can see below that foreigners also contributed to the strong buy pressure starting Nov ’23.
What has driven the long rally in US equities despite massive Fed tightening? There wasn’t as much tightening of the overall US liquidity system as the rate hikes and tapering suggested, and foreign flows bought momentum to further buoy stock prices.
Rate hikes used to play a bigger role in the tightening of US liquidity because higher interest rates contracted credit creation, which was the main driver of liquidity. You can see that the stock market was more sensitive to rate before 2010. After the financial crisis with the introduction of quantitative easing and other policy tools, overall US liquidity became the main driver of markets. Rates still play an important role – especially in how markets are pricing in the future path of interest rates and how financial assets are discounted today – but have become less important than before.
Disclaimer: Does not constitute investment advice, represents author’s own research and opinions. Make investment decisions at your own risk.