THE FED JUST FAILED | Why The Market Is Falling

What's up guys, it's Graham here. So by now, most of us have probably heard the phrase, "The Federal Reserve is beginning to crash the market." Throughout the last few days, that has been the number one headline. The stock market began to sell off, cryptocurrency dropped 11% seemingly overnight, and to date, 40% of the NASDAQ is now down 50% or more. In fact, Bloomberg even reported that at no other point since the bursting of the dot-com bubble had so many companies fallen like this while the index itself was so close to a peak. Not to mention, when you hear terms like "the balance sheet runoff," "taper tantrum," and "a reduction in net asset purchases," it's confusing, and it's worth breaking down so that you'll have a better grasp on what's about to happen and why investors are beginning to panic.

But before we go into that, if there's one thing you can do, it's smashing the like button for the YouTube algorithm. Doing that helps me out tremendously; it's totally free! And if you could do that in the next 4.2069 seconds, I'll show you this picture of a really cute baby lobster. Wait, no, not that baby lobster; this baby lobster!

All right, so first, here's what's going on and why the markets went up so much to begin with. And you're going to want to hear this out because once you understand this, everything else is going to make sense. In March of 2020, the Federal Reserve lowered interest rates down to zero percent as a way to soften the impact of coronavirus throughout the economy. The worry was that when everything is shut down, people would begin to spend less money. That would cause prices to fall, people would then begin to hoard their money, and that would send us into a 1920s-like Great Depression. So by lowering interest rates, that works as a way to encourage people to spend more money and borrow more money, thereby pushing us through a very difficult time.

But how they went about doing this is what's causing the problem today. One of the ways of increasing money supply and lowering interest rates is what's called open market operations. Even though it sounds like a James Bond objective in GoldenEye, the entire concept is actually rather simple. First, you have what's known as a bond; this is basically just an IOU from a city, state, or government that says, "If you lend me money, I will pay you back with interest." But how much interest they pay is simply a form of supply and demand. The less demand there is for these IOUs, the more interest they have to pay to entice people to buy them, and the opposite is true when there's a lot of demand, and they don't have to pay out as much.

So as a way to lower interest rates, the Fed went in and bought up all of these bonds, driving up the demand and lowering the return. So the end result is pretty much more money, lower rates. Of course, as we could see, their balance sheet throughout the last two years has more than doubled as they purchased more and more bonds within their own portfolio, and as a result, the market loved it. Low interest rates meant that companies could expand at much faster rates; valuations were higher because people had more money to spend. And that's worried some people who start thinking, "What's going to happen when the Fed stops buying these bonds and printing more money into the economy?" Well, we're gonna find out because that's what brings us to today.

See, from the very beginning, we knew that low interest rates, bond buying, and asset purchases would be reduced. But what we didn't know is how quickly that would occur, and that's where we have the first problem. As inflation began to increase throughout the last year, people began to worry that the Fed was keeping interest rates too low for too long, with too much money entering the economy. Although it was still too early to tell if record high inflation was a result of too much money printing or from supply chain bottlenecks that caused prices to increase. After all, if something goes up in price because it suddenly becomes a scarce material, that's not inflation, that's just normal supply and demand.

So if higher prices were a result of supply chain issues, eventually prices would begin to normalize, and things would decrease, but that's not happening as fast as they would like. That's why they just recently signaled that inflation is lasting longer than they anticipated; it's higher than they thought. And to counteract the rising prices, they're going to be reducing their bond buying and subsequently raising rates faster than expected.

How are they doing this, and why is the market freaking out, you might ask? To start, they do this in a few ways, and the first is what's known as a balance sheet runoff. That just means when those bond IOUs mature and come due, the Federal Reserve could choose to take that money out of circulation instead of reinvesting it. It would be no different than them loaning you ten thousand dollars for a year, and then when you pay it back, they take that money and instead of loaning it to somebody else, it's just poof, gone.

In terms of how much this actually amounts to, though, a recent report showed that four and a half trillion dollars would unwind at a rate of more than 50 billion dollars a month. The second we have a term known as tapering. See, up until recently, the Federal Reserve was buying 120 billion dollars a month of treasuries and mortgage-backed securities as a way to inject money into the economy. But now they're moving forward with the plan to reduce that number by 30 billion dollars a month until by the end of March, they're no longer buying anything else.

And third, we have raising interest rates. At the end of the day, the goal is that interest rates will begin to increase now that unemployment has dropped to 3.9%. The biggest fear is the Fed is going to be removing liquidity from the markets, taking excess money out of supply, and draining all of that sweet, sweet leverage that keeps prices higher than normal. But let's be real, we all knew this was going to happen from the very beginning. So why is it now that the market is beginning to panic? That's because of a few specific comments they made, and Investors.com has broken this down for us perfectly.

They quoted that many participants judged that the appropriate pace of balance sheet runoff would likely be faster than it was during the previous normalization episode, which is basically just another way of saying, "Our economy is doing better than expected. We have more money in circulation than expected, and inflation is higher than we expected. Therefore, we could have faster rate hikes and a faster runoff than expected." But how does that compare to the last time this happened? Well, look no further than the mortgage crisis of 2009 when the Federal Reserve did something eerily similar to what we're seeing today.

After the housing market crashed, they began buying mortgage-backed securities in an effort to stimulate lending and get the housing market back on its feet. But in 2013, they announced that they would begin to think about raising rates, and without one little comment, the market went into a full-scale panic. Investors suddenly stopped buying mortgage-backed securities, interest rates spiked out of nowhere, volatility went crazy, emerging markets tumbled, and the thought was that this was the beginning of the end. However, much of that proved to be an overreaction because the Fed didn't actually begin raising interest rates at the time of the announcement.

And after some time, things went back to normal until 2018. This was a time when our economy was growing at a consistent rate, unemployment was low, and the Federal Reserve began raising interest rates back to historically neutral levels without stifling the growing economy. But as a result, the stock market posted its worst year in a decade as the S&P 500 fell 20% from September 2018 to January 2019. But just as the S&P 500 was about to hit a bear market, the Fed stepped in and said, "Uh, hey guys, our bad! We're actually going to raise rates a lot slower! How's that?" And then six months later, after receiving a lot of pushback, they did the unthinkable: they lowered rates for the first time since 2008, causing the market to turn back around and resume its uptrend.

So in terms of what's going on today, the market's already reacted quite negatively. And that brings us to this sobering reality that not everything just moves up. Forty percent of the NASDAQ is now down 50% or more from their all-time high, which is almost a record. In this case, as interest rates increase, tech and growth stocks decrease because more expensive borrowing eats away at the value of future cash flow, and as a result, they fall. On top of that, as bond yields increase on the expectation that interest rates are going to be going higher, growth and tech stocks look less appealing because when other risk-free investments offer a higher return, people begin to scale back on more speculative options.

Although when it comes to this, here's where things start getting quite interesting. This recent study broke down investors into two categories: one considered the choice between a risk-free 5% return and a risky 10% return, while the second group made the choice between a risk-free 1% return or a risky 6% return. Now, in both of these scenarios, the risky asset pays the exact same 5% more, but the results were vastly different. They found that low risk-free returns caused significantly more risk-taking for higher-yielding assets, even though technically the difference in payout was always the exact same. Those findings began to normalize when risk-free interest rates were higher, even though the riskier assets still paid more.

And for all of you visual learners out there, that just means that when interest rates are zero percent, 70% of their portfolio went into risky investments, but when interest rates are 5%, that dwindles down to 50%, reflecting a more balanced portfolio. The conclusion they found was just this: people form a reference point for what they should make from an investment, and when interest rates drop below that amount, investors are more likely to make riskier investments to seek even higher returns.

In addition to that, if the riskier investments end up paying substantially more than the risk-free investments, then investors are more likely to go for it. In this case, going from 5% to 10% is double, but going from 1% to 6% is a 5x return. So when viewed in proportion to low interest rates, riskier investments seem even better. And what's even more surprising is that yield chasing, as they call it, does not diminish with education, wealth, and investment experience, meaning this applies to pretty much everyone out there on a broad scale and might help explain what's going on in the markets today.

It's also the most likely reason why cryptocurrency was selling off as well. Throughout the last week, we've seen a sharp sell-off in pretty much everything. Bitcoin dropped to forty thousand dollars, and Ethereum fell to lows of three thousand dollars, pretty much retracing back to their September lows. In a way, higher interest rates disincentivize risk-taking, and when investors fear less about rising inflation, they take a risk-off approach as they sell off riskier assets and move into safer companies.

Now, even though a power outage in Kazakhstan, who's responsible for nearly a fifth of all Bitcoin mining, certainly isn't helping, the reality is higher interest rates are going to lead to less risk-taking. And for the time being, Bitcoin, as well as most other cryptocurrencies, fall into that category. Combine all of that with excess leverage, and that is most likely why we're seeing a sell-off now.

Anyone invested in cryptocurrency should understand that it's extremely volatile, and it's not like this hasn't happened multiple times in the past. But it's important to remember that you can lose money, and as long as you plan to hold for a long time, then most likely the best thing that you should do is just hold as usual and don't panic.

As far as where the market's going, the simplest answer is: it's going back to value. The market over these two years has rotated from stay-at-home tech to retail and travel, back to tech, and now back to safe investments that trade on their fundamentals. Why? Because even though they're boring and make less, they're safe, they're consistent, and people know what to expect. Over the last two years, the charts very much demonstrate exactly this: bonds go up, value goes up. That means that cash-heavy, fundamentally sound businesses could take the rain during a time where interest rates begin increasing. Dividend companies could also fall into this as well for their consistent cash flow.

So even though this might seem like a nerve-wracking time, at least take this as an opportunity to make sure that you're properly diversified and have your money spread throughout both speculative and value companies to make sure you're not taking on more risk than necessary. It's a good reminder that not everything just goes up endlessly day after day. And it's important to build a portfolio that reflects that. Plus, at the very least, I hope this explains why the market had such a sudden reaction, how interest rates affect the future value of your money, and where prices could possibly move throughout the next year.

So thank you guys so much for watching! Don't forget to subscribe. My Instagram is right here, and feel free to add me on my second channel, The Graham Stefan Show. I'm posting there every day. I'm not posting here, so if you want to see a brand new video from me every single day, make sure to add yourself to that. Thank you so much for watching, and until next time!