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You’ve seen all the headlines this past week.

“S&Ps down 10% from the February highs.”

“Trump not ruling out a recession.”

“The magnificent seven just had their worst day since July.”

“Hedge funds unwinding risk at the fastest rate in over two years.”

Certainly, markets seem to be in turmoil as new headlines break almost hourly charting a different course on tariffs, foreign policy, and cost cutting measures within the government.

We’ve seen a pretty classic flight to quality trade, where investors are shedding risk assets (like equities and crypto) in favor of “safe haven” assets, like U.S. Treasuries.

But what may be hard to discern as an outsider is the extent to which a seachange has happened in terms of WHAT the market is reacting to.

For as long as we can remember, the market has been looking to the Fed.

In the early 2000s, it was “how does the actual path of monetary policy line up with our expectations?”

Post-GFC, it was “the Fed is reacting to negative news with quantitative easing, which is creating conditions for a bull market.”

Post-QE it was “bad news is good news, because signs of weakness mean more stimulus from the government!”

We’d reached almost an inverted lens of the market’s perception of economic data, where bad news was GOOD, because it would lead to government stimulus.

Well, times have changed. Bad news is, in fact, bad.

The market is no longer trading on just the fundamentals and expectations of monetary policy. And we are possibly headed into a period of stagflation.

What is “stagflation”?

Stagflation results when we experience high inflation (rising prices) and high unemployment (low growth) simultaneously. 

Normally inflation and unemployment don't rise together, so stagflation presents a bit of a quandary. 

The Fed’s toolkit for addressing inflation (i.e., raising interest rates, shrinking the balance sheet) might hurt already-weakened growth. And the Fed’s toolkit for addressing slow growth and high unemployment (i.e., lowering rates, growing the balance sheet) might drive prices even higher.

Stagflation points to a Fed that has its hands tied.

Historically with periods of stagflation, the inflation side of the equation has risen due to specific exogenous factors, like the oil spike in the 1970s.

Recall that in the late ‘70s/early ‘80s, the Fed hiked interest rates as high as 21% and implemented quantitative tightening (reducing the monetary supply) to finally get inflation under control.

The Fed is already shrinking its balance sheet and has paused rate cuts. Are rate hikes on the horizon despite unemployment numbers edging higher?

Regardless of how you may or may not feel about them, the current shocks to the status quo are all coming from the executive branch of government, and THAT is what the market is reacting to. 

Not the Fed.

The mechanisms of monetary policy are taking a serious backseat to fiscal policy decisions. 

This is, to some extent, an anomaly — at least in the US financial markets over the last several decades.

We are only weeks into this new administration. The pace of change doesn’t feel like it can remain this high indefinitely. 

So while I do not envy risk-takers who have to navigate this new reality, volatility creates opportunity.  Good luck out there, friends!