We hear the word pivot very often on social networks or media at the moment. Much of the fluctuation in the financial markets in recent months is due to speculation regarding the Fed’s pivot. But what is a pivot? Is it really significant of a bullrunot ?
Definition of a pivot
The term pivot is used when the FED decides to change its vision/outlook in the face of a change in the environment. Generally, there are two main kinds of pivot:
- The pivot when moving from restrictive to accommodative monetary policy
- The pivot when moving from accommodative to restrictive monetary policy
The Central Bank uses several tools to control inflation, price stability and also to ensure full employment. One of its main tools remains the Fed’s interest rate.
Fed fund rate
This is the short-term rate, the one we hear about everywhere in the media when there are changes, such as rate increases or decreases, or when it remains neutral (unchanged).
This rate is mainly used for short-term borrowing/lending between the different banks. When an institution (deposit bank) holds excess funds in its reserves, it will lend funds to another institution which needs more cash. This rate is determined by the market, but also by the FED during the FOMC.
The impact of interest rates on economic cycles
It is, in a way, credit that creates the cycles. And yes, without credit, there wouldn’t necessarily be a cycle, it would be much more linear. This is why economic cycles and market performance are highly dependent on credit and interest rate fluctuations. Therefore, it is important to understand the actions put in place by the FED such as when it decides to raise or lower its key rates.
When does the Fed pivot?
Central banks do not change monetary policy without there being a change in the narrative, such as a change in conditions with respect to their mandate, for example. Before performing a pivot, there is usually a pause. Either a stop on the fall or rise in rates. Here are the two main mandates of the FED:
- Price stability / Inflation at the target rate
- Full employment
If one of these narratives changes, there is a good chance that the Central Bank will act. This is the case of 2022 with the rise in inflation, the FED had to raise rates to control inflation. Generally, they are used to raising the key rate above the rate of inflation.
Here is the inflation rate and the key rate:
In 2000 or 2007, the Fed had pivoted, because the slowdown in growth persisted. Subsequently, it accelerated the process of lowering rates, because mandate number 2, “full employment”, was in the process of slowing down sharply (rising unemployment). This slowdown had a significant impact on growth and therefore on the financial markets.
Here is on the graph the non-employment rate and the pivot with the key rate:
The pivot for 2022?
For now, we know that the Fed’s last speech was quite restrictive. The focus remains clear, controlling inflation. Consequently, the last rate increase was 75 basis points or 0.75%. The key rate is now between 3.75 and 4%.
It is clear that the Fed is not going to keep up the pace of raising 75 basis points at every FOMC (FED meeting). This is why it is likely that she will end up reducing the increases thereafter knowing that the rate of change of inflation is lower. Maybe another 75 basis points for the next meeting in December. Then, the logic would be to continue to increase, but at a smaller dose as inflation is still well above the target rate of 2%. When we say slow down, it does not mean that we have a pivot. It just means reducing the amount of increases, as the Central Bank of Canada did, for example, in October.
In theory, a pause is not a pivot either. It is rather a neutral position before starting a pivot, it is a transitional phase.
Hope for a near-term pivot remains implausible. This would require a rapid change in the level of inflation, a liquidity crisis or rising unemployment. If we take the current data, all things being equal, the pivot is not possible for 2022, but no longer for 2023.
Why ?
As long as the employment figures remain solid and inflation remains high, there is no question of cutting rates immediately. The stakes will be high between not pivoting too soon or pivoting too late.
monetary policy and markets
Generally, central banks are supposed to raise interest rates when we are accelerating in growth. Therefore, an increase in rates does not necessarily mean “fall in the markets (as was the case in 2022) especially if we are accelerating growth. This is precisely an action by the FED to better control the inflation created by growth. This is the case for 2016 and 2017, see the performance of the S&P 500 and the key rate on the graph.
However, when the Central Bank raises rates or continues to raise rates when we are in a growth slowdown, it can have strong impacts on financial markets. By this I mean that it generates more volatility in general.
Here are just a few examples, such as in 2022 or 2018. Drawdowns are greater during these periods of rate increases.
Does pivot mean “bullrun” ?
No not necessarily. This is where I find it important to analyze the impact of rising rates before saying that a pivot can push the markets to new highs.
In the majority of cases, a pivot often precedes a recession and the Fed tends to pivot too late.
Here is a table that highlights the moment of the pivot and the index of the S&P 500:
But there are specific cases where a pivot spawned a new bullrun like in 1995 or 2019. In both of these cases, growth at the time of the pivot was still high at around 2%. As a result, growth had not been greatly impacted, it was able to absorb interest rates, and the financial markets went to new highs.
Conclusion
The FED is an important source of guidance for the financial markets. For the moment, it is still too early to say that a pivot can save the American economy as long as it has not taken place. We often say “Don’t fight the FED” or ” don’t fight the FED”, I think it is all the more important here to wait for her to confirm a break before a pivot in order to analyze the damage at that time.
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