Site icon Directional Advisors

What I Care About This Week | 2022 Sep 12

worm s eye view of buildings

Photo by Johannes Plenio on

by Franklin J. Parker, CFA

The Summary

The Details

The past few years have turned most professional investors into Fed watchers, and this begs the question: why does the Fed matter so much?

The Federal Reserve has the responsibility for controlling the money supply and influencing interest rates. This supports their dual mandate: to keep inflation low and employment at full capacity.

These two tools have the side effect of pushing market prices around, though some of that is intentional. By raising the rate they pay banks, the Fed is able to pull cash out of the general economy, making less credit available to businesses. This tends to constrain business activity. Of course, the inverse is also true—markets have benefitted from low rates over the past decade.

Increasing the amount of cash in the economy tends to push market prices up—both because investors themselves have more cash to put to work, but also because it increases the amount of credit available to businesses. The inverse here is also true.

Given the power of these forces, central banks can exert a lot of influence over market prices. During times like this, when the moves are very aggressive, prices will respond quite strongly. Of course, markets benefitted from aggressive moves in 2020, but those moves served to boost prices rather than pull them down.

In the end, however, prices will tend to follow the fundamentals of the economy. Profit growth is what drives prices, so while the Fed influences valuations in the short term, it is these bigger forces that will drive longer-term prices.

Chart of the Week

One way to measure the amount of cash in the economy is to look at the amount of assets on a central bank’s balance sheet, which is what this week’s chart shows. When a central bank “shrinks their balance sheet,” they are reducing the amount of cash in the economy, constraining credit, and generally slowing down the economy.

As this week’s chart shows, central banks globally are decreasing the size of their balance sheets, and at a quickening pace. Markets are reacting negatively to this change in policy.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

Exit mobile version