Albert Einstein defined insanity as doing the same thing repeatedly and expecting a different result. We may look back on 2022 as a year when the Federal Reserve repeated a mistake made in 2021: consistently relying on stale data that results in a reactive instead of a proactive monetary policy.
Investors have bidden a not-so-fond farewell to 2022, a year in which investment savings suffered significant losses. Inflation, war and geopolitical bifurcation of the world’s nuclear powers created an almost perfect bearish storm for stocks and bonds.
An Ugly Year
The S&P 500 is the most diversified U.S. stock market index, and it’s tracked by the world’s biggest ETF, the SPDR S&P 500 ETF Trust (SPY). After closing at 4,766.18 on Dec. 31, 2021, the S&P 500 moved 19% lower to settle at 3,839.50 on the last trading day of 2022.
The chart above shows SPY’s decline to $382.43 at the end of 2022 from $474.96, where it ended the previous year with a 19% drop. SPY has $354.6 billion in assets under management and trades an average of nearly 72 million shares daily. SPY charges a 0.09% expense ratio, accounting for the slight underperformance of SPY compared with the S&P 500 in 2022.
A Bearish Year for the Long Bond
The 30-year Treasury bond futures dropped 22% in 2022, moving to 125-11 as of Dec. 30 from 160-14 at the end of 2021.
The chart above shows the iShares 20+ Year Treasury Bond ETF (TLT) plummeted 33% last year to $99.56 per share. TLT has $26.9 billion in assets under management and trades an average of nearly 19.9 million shares daily. TLT charges a 0.15% expense ratio. It declined more than the 30-year Treasury futures because of the yield curve differences between 20- and 30-year government debt securities.
The Wait to Address Inflation
A hallmark of 2022 was the Fed waiting too long to adjust its monetary policy path to reflect rising inflationary pressures. Throughout most of 2021, the central bank and Treasury officials in Washington D.C. attributed rising inflation to “transitory” factors created by the global pandemic.
However, the Fed and Secretary of the Treasury failed to see that the tsunami of central bank liquidity and the tidal wave of government stimulus were creating the conditions for an inflationary hurricane.
In all fairness to the Fed and Treasury, the war in Ukraine was an unexpected event that poured fuel on the inflationary fire. Supply-side factors caused food and energy prices to soar in early 2022, pushing inflation to the highest level since the early 1980s.
The Fed began to increase the fed funds rate from zero in March 2022, pushing it to a midpoint of 4.375% at the end of the year. Moreover, quantitative tightening at a monthly $95 billion rate put upward pressure on rates further out along the yield curve.
The bottom line is, despite warnings and rising inflationary data, the Fed waited too long to increase interest rates, causing inflation to soar. Even though the fed funds rate was at 4.375% at the end of 2022, the latest CPI and PPI data at over 7% make real interest rates negative at the current level.
Rising interest rates and the war in Ukraine have pushed the dollar index to its highest level in two decades. The world’s second-leading reserve currency, the euro, accounts for 58% of the dollar index.
A rising dollar and higher interest rates cause earnings for U.S. multinational companies to decline because of higher financing costs and competition from foreign companies. While higher rates battle inflation, they choke economic growth.
Some economists and market participants believe the Fed’s hawkish monetary policy path will cause a severe recession in 2023. If inflation remains high because of supply-side war-related reasons, stagflation could emerge over the coming months.
The central bank’s toolbox doesn’t include tools to tinker with stagflation. Inflation requires increased interest rates; battling a recession typically causes a dovish monetary policy approach.
The Fed has chosen to focus on inflation and ignore the rising recessionary pressures. Time will tell if we look back at 2022 as the year when the Fed made another mistake by neglecting the monetary policy impact that caused an economic contraction.
Will 2023 Repeat 2022?
One of the takeaways from the Fed’s policies in 2020 through 2022 is that a data-driven approach is reactive. The uber-dovish 2020 and 2021 approach reacted to the pandemic, while the rising consumer and producer price index data caused an uber-hawkish 2022 approach.
Stocks and bonds are real-time indicators of the market’s sentiment and current economic landscape. A continuation of hawkish monetary policy will likely weigh on stocks and bonds, sending SPY and TLT to lower lows over the coming weeks and months. However, a Fed pivot could ignite dramatic rallies.
The path of least resistance for SPY and TLT has been a function of reactive monetary policies. The U.S. central bank and Treasury have real-time data from the domestic and global markets that could establish a more proactive stance.
If the markets are correct and the Fed has gone too far on its hawkish monetary policy path, it would be more evidence that Albert Einstein would define the approach as insane. Expect lots of volatility in SPY and TLT over the coming weeks and months.