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The Federal Reserve Is Trying to Talk Its Way Out of a Prison It Created

Last Updated September 23, 2020 2:00 PM
Laura Hoy
Last Updated September 23, 2020 2:00 PM
  • The Federal Reserve’s market backstop has created a new breed of ultra-risky investors.
  • As the market soars to new highs amid economic turmoil, Powell is getting anxious.
  • At some point, the central bank will have to wean investors off of its stimulus lifeline.

On Tuesday, Federal Reserve Chair Jerome Powell cautioned that the U.S. economic recovery is fraught with “significant uncertainty.”

Powell’s comments came one day after the central bank unexpectedly intervened in financial markets and reversed the stock market’s decline. Powell appeared to be trying to talk traders down from a cliff that the central bank has inadvertently created.

Federal Steps in to Stop a Stock Market Crash

Last week was a painful one for the army of day traders that recently piled into the stock market. Share prices fell as pandemic worries weighed on confidence. Some began to question the validity of the stock market rally.

Conveniently, the Fed announced Monday that it was expanding its bond-buying plan to include individual corporate bonds rather than just exchange-traded funds. 

federal reserve, stock market, Jerome Powell
The LQD ETF rose to all-time highs after the Fed’s announcement. |Source: Bloomberg 

The news sent LQD, a popular investment-grade bond ETF, to all-time highs. It raised questions about the Fed’s intentions . The bond market didn’t appear to need rescu ing, so why did the Fed step in?

Federal Reserve, S&P 500, stock market
The Fed conveniently announced its expanded bond-buying plan as the S&P 500 hovered near key resistance levels. | Source: Bloomberg

You could argue that part of the Fed’s decision was motivated by the stock market, which at the time was in a downward spiral. At the time of the Fed’s bond-buying announcement, the S&P 500 was nearing key support levels that, if broken, could indicate further downward movement. 

Investors are Addicted to Risk

stock market, federal reserve, stock market crash
If it has letters, buy it. Dave Portnoy has been an outspoken advocate of taking stock market risks. | Source: Twitter 

Whatever the reason, the Fed intervened, and once again, risky investment decisions were rewarded. The ‘stocks only go up’ mantra has been adopted not only by Robinhood’s army of millennial traders but by hedge fund managers as well. 

A Bank of America survey showed that almost 80% of fund managers believe the market is overvalued. Still, they piled into stocks over the past month  at a record pace. 

Risk has become traders’ drug of choice since March, and the Federal Reserve is the dealer. The bank’s unlimited intervention is encouraging risk-taking among investors . But in keeping financial markets from collapsing, the bank is only stacking its house of cards higher.

The Fed is Trying to Reel Traders Back In

Encouraging overzealous traders to dump their stimulus checks into the stock market  probably wasn’t the Federal Reserve’s intention. But now that the market is trading near all-time highs and investors are still loading up on stocks, the central bank is faced with a dilemma.

Pulling away from markets now, or anytime soon for that matter, could end with a crash that will leave many people bankrupt. But continued intervention will only further this cycle. 

Jerome Powell, federal reserve, stock market
Jerome Powell is trying to offer traders a dose of reality, but as long as the bank is printing money, they won’t listen. | Source: NICHOLAS KAMM / AFP

That could explain Powell’s rhetoric on Tuesday, which echoed similar statements he made last Wednesday. 

The levels of output and employment remain far below their pre-pandemic levels, and significant uncertainty remains about the timing and strength of the recovery.

Later, he pleaded with markets to be sensible, claiming the Federal Reserve doesn’t want to “run through the bond market like an elephant.”

Powell to Investors: Take Your Foot off the Gas

the dow, nasdaq, S&P 500
Share markets are near all-time highs – perhaps its time to pump the brakes? | Source: Yahoo Finance 

Jerome Powell is appealing to investors’ logic. He’s hoping caution will return, not with a stock market crash, but at very least with a plateau. After all, how much higher can the market go?

Investors have very little to base their optimism on outside of a few promising economic data points . Many firms pulled their forward guidance  because of the pandemic. That’s left investors to guess how badly they’ll be hit and when they’ll recover.

Powell also cautioned that small businesses and the jobs they support are at risk. 

If a small or medium-sized business becomes insolvent because the economy recovers too slowly, we lose more than just that business. These businesses are the heart of our economy.

Locked in a Dangerous Cycle

None of that is new information. Traders were aware of the labor market risks and fragility of the economic recovery.

As the adage goes, actions speak louder than words, and in the Fed’s case, that’s exactly what’s happening. The bank’s decision to inject funds at the moment it did was confirmation that the Fed isn’t just a safety net for the market anymore ; it has become the market. 

Disclaimer: This article represents the author’s opinion and should not be considered investment or trading advice from CCN.com.