Stock Market Insights: Federal Reserve carburetor

DR. RICHARD BAKER, AIF®, is the founder of and an executive wealth advisor at Fervent Wealth Management. https://www.facebook.com/Dr.RichardBaker

"Now we listen to it idle.” My dad worked on small engines as a side job when I was a kid. I remember watching him adjust a cantankerous carburetor and then stepping back to watch it. I asked him what he was waiting for, and he said, “Now we listen to it idle,” to see if it needs more adjustment. The Federal Reserve is a lot like an economic carburetor that controls the fuel supply, and at this month’s meeting, they decided to listen to it idle.

As expected, the Federal Reserve announced on June 14 that it paused its interest rate hiking campaign. This is the first time they haven’t raised rates in ten consecutive meetings. Although the pause is a nice break for the market, the Fed hinted there might be more increases later this year because they have yet to hit their goal of 2% inflation.

The inflation rate has dropped to half of what it was at its peak, but it is still too high. If the Fed had tightened the market enough to squeeze inflation, we wouldn’t see stocks start a new bull market, the housing market rebound so soon, or long-term Treasury yields be below the inflation rate. So why pause now if the job isn’t done?

Like my dad with the carburetor, the Fed needed to keep the market idle for a little bit to see how their adjustments were playing out. It can take months and sometimes years to see the full effect of Fed rate adjustments on the economy. Also, there is still some real concern over the banking sector that took the aggressive rate hikes on the chin. I agree with the pause.

I still feel good about the market at year-end, but I’m starting to prepare for some near-term volatility.

I have established a somewhat defensive posture on the accounts I manage by reducing the stock allocation and slightly overweighting to fixed income.

There are three reasons why I’m doing that. First, I think there could be a short recession in the next year. Second, stocks have had strong returns year-to-date, and I want to protect that gain. Lastly, the bond market looks more attractive because it has some of the best yields in decades.

Back to my carburetor analogy, a carburetor supplies fuel and air to the engine differently at idle than when the throttle is wide open. If the engine doesn’t run well at idle, then it won’t run very well when you stomp on the gas. Whether you are talking about a Briggs and Stratton engine or the largest economy in the world, it’s critical that it runs well at idle before making further adjustments.

I won’t go into the fact that carburetors get gummed up. Hopefully, the politicians won’t keep gumming up the economic carburetor. Have a blessed week! www.FerventWM.com