Hard to have faith in the Fed's new religion

The Fed has found a new religion. Seen the error of its ways. The most powerful man in the financial world, Jerome Powell, has come to realize that perhaps endless injections of monetary stimulus and artificially low interest rates might have some negative side effects after all.

Like the highest inflation in 40 years.

But Powell and the Fed governors have seen the light. From now on, their approach to monetary policy will be different. Strong asset returns are no longer a priority. Reining in inflation is all that matters.

That is what we are being led to believe. More accurately, that is what financial markets are suggesting will happen. The S&P 500 is suffering through its worst start to a calendar year in 80 years because, more than anything else, investors are afraid of high inflation and the less friendly Fed policy required to fight it.

Let's be clear about two things. First, the headwinds facing the market in 2022 have absolutely become more challenging. Second, the Fed will raise interest rates several more times this year. The question we want to address is this: "How much pain is the Fed willing to endure in its battle against inflation?" And by "pain," we mean market losses.

Recent comments by Powell and other Fed governors indicate a willingness to raise rates aggressively in order to tame inflation, which measured 8.3% in April from a year ago. Following the tough talk, consensus expectations now call for nine quarter-point rate hikes by the Fed this year.

This feels like an appropriate time to be contrarian. After a half-point hike on May 4, the Fed is one-third of the way down its path toward the consensus target. Don't be surprised if they don't get there. It's hard to have faith in the Fed's commitment to aggressively raising rates given the same decision-makers have a track record of prioritizing market stability above all else.

The stock market is already pricing in a strong likelihood of an economic recession, in part due to expectations of significantly higher interest rates. But has the Fed really found a new religion? Or is it just new rhetoric?

We believe the Fed genuinely wants to bring down inflation. We have less conviction they will maintain such an aggressive course if equity and bond prices continue to deteriorate.

The S&P 500 is nearing the start of a bear market (defined by a drop of 20%). The Nasdaq has already fallen 30% from its peak. The major bond benchmarks have lost 10% year to date, which would be their worst calendar year performance in history if 2022 ended today.

It's impossible to know how far we are from a market bottom or how quickly stocks may recover once we get there. There is a point, however, at which Powell and company will adjust policy (or at the very least, hit the pause button) in order to calm what has been a quickly receding financial tide. Whether or not they should is not as important as the historical evidence that they always have.

Market sentiment, by several measures, is especially pessimistic. If stocks begin to recover on their own, then higher rates will be easier to digest. And if the negative momentum continues, rest assured that tighter Fed policy will prove to be transitory.