Great Financial Crisis Of 2008

Ever since the Great Financial Crisis of 2008, financial markets have relied on the concept of the “Fed put”, basically downside insurance that if and when we face market crashes, the Federal Reserve (“the Fed”) will step in to pump liquidity into financial markets by adjusting interest rates, allowing for cheaper credit, to prevent a severe crash due to forced selling, as market participants scramble to raise cash liquidity. This feature of modern monetary policy has helped to stabilize markets during times of turmoil and has helped to create a long and broad bull market for most of the last 13 years. In March of 2020 when the world was going into lockdown as the first wave of Covid-19, the Fed stepped in again with an unprecedented liquidity injection, and this act quickly stabilized markets and sparked the rally we’ve enjoyed for the past 20 months.

Why The Surprise?

But nothing lasts forever, and the writing has been on the wall for quite some time that this period of Fed support would eventually draw to a close. So why does it seem to be catching us by surprise all of the sudden? Investors seem to be stuck a little between a rock and a hard place right now. Inflation worries mean that just sitting in cash is not a great idea, and during periods of inflation, hard assets like real estate and commodities generally outperform. The prospect of inflation is also one of the biggest narratives driving investors into crypto, especially as a store of value. Yet just as inflation is really picking up we have seen broad pullbacks across crypto markets.

In The Hands Of Inflation

Inflation has forced the Fed’s hand, and with the release of the Fed minutes from the December meeting we got a deeper look into the discussions about how the members plan to navigate the next year. The focus has shifted almost entirely to fighting inflation, and when it comes to that, the Fed only has a couple tools at its disposal, and all of them involve reducing liquidity in the financial markets either by raising rates or balance sheet reductions. As the prospect of monetary policy tightening grips markets, investors are looking for places to hide, and they are aggressively selling anything associated with growth. Crypto seems to have gotten caught up in this “get out of growth” trade.

To Rise Or To Fall

There is still a massive amount of money sloshing around in the world financial markets, and even as the Fed starts to remove liquidity, it won’t all dry up immediately. As investors run for cover and sell out of some assets, they will likely move to cash or to treasuries. Given the impact inflation has on cash, and the potential for rising interest rates to devalue treasuries, investors may move right back into other assets. This will create a period of rotation and chop where some asset classes sell off violently while others stay calm or even rise, only to reverse a day or a week or a month later, as investors continue to scramble to find assets they feel safe in.

What Direction Are We Going?

Right now, crypto and growth equities are bleeding even while equity indexes stay elevated. The overall market lacks clear direction, with money just being pushed frantically around from one asset class to another. It’s hard to know how long this period will last, but for the time being it may be wise to prepare for continued chop and consider keeping some liquidity of your own on the side.

The opinions expressed in the CrossTower Classroom are those of the author(s) and not necessarily that of CrossTower. We appreciate diverse perspectives of our employees and we thank them for having a voice.