The Fed’s New Year

Nathan Eigerman
Lee Adaptive Strategies Update
Monthly Commentary
January 2022

2022 opened with a difficult month for the equity markets. The S&P 500 lost -5.17% on a total return basis, even after significant late month rallies that saw it improve from mid-month lows nearly twice as bad.

This was the worst performance in the markets since February and March of 2020, making it the worst month so far of the pandemic era. It is easy to imagine that this is the end of the party that began 22 months ago. And the start of a new year certainly adds to the sense that this is a new regime of some kind.

On the other hand, it is always a good idea to counterbalance the human tendency to emphasize the most recent past with perspective from the not so recent past.

May 2019 saw the S&P 500 give up -6.35%. Remember that? We are guessing you do not. There was anxiety that month about trade relations with China and the Uber IPO went poorly. How about October and December 2018, when the S&P lost -6.84% and -9.03% respectively, driving Q4 of that year to a discouraging -13.52%? The most recent January with a bigger loss is that of 2009, when the S&P declined -8.43%. It finished that year up 26.46%.

In retrospect, none of these poor months were the start of a new era. (Although January 2009 was close.) If this sounds like we are trying to be reassuring, we are not. On the contrary, we only mean to make the point that the markets remain risky and unpredictable. January’s results are not themselves a clear indicator of anything in particular.

For those that feel a need to name a cause of market movements, January had an easy candidate. The market declines were due to the Fed rattling its sabers on inflation, making it very clear that they will turn off the money spigot and raise interest rates significantly in the near future.

Although we agree that communications from the Fed had a negative impact, we object to the tidiness of laying all blame there. To begin with, it is not obvious that January’s Fed news was that inconsistent with December’s expectations. Moreover, there is a significant hindsight bias at work. Had the S&P gained 5% instead of losing it, observers might now be saying that the gain was due to reassurances from the Fed that it will do what it needs to do to curtail inflation.

Our biggest concern about the Fed, inflation, and the equity markets continues to be that investors may not be grasping the scale of the inflation problem. It seems obvious that there exist many market participants who fear that the Fed will overreact, that their medicine will be too strong and will harm the patient. Are there many investors who fear the opposite, that the Fed will underreact until it is too late?

Below is a chart showing 3 month T-Bill rates and rolling 12 month inflation rates for the past 40 years.

Data Source:

If you are willing to make the assumption that investors expect the most recent 12 month rate of inflation to continue for the next three months, then the spread here between the nominal interest rate and inflation is the expected real rate of return. From the start of this data set in 1981 to the end of 1999, the real rate averaged 3.00%. From the beginning of this century through 2020, the average real rate was modestly negative, at -0.51%. The final observation here, for December 2021, is 0.06% for T-Bills and 7.12% for inflation, for a real rate of -7.06%.

For investors lacking grey hair, data from the 1980s and 1990s may seem to be relics from an ancient civilization, a strange lost culture in which a person actually expected to profit, in real terms, from owning short-term Treasuries. Those of us with grey hair do not think of it as being so alien, but for the sake of argument, let us ignore history prior to the dot com bubble and consider real rates of approximately zero to be the norm.

Current real rates are quite a long way from zero. Indeed, they are at a negative level at which there is a threat of a self-reinforcing spiral. Holding rates so low necessitates the expansion of the money supply, which in turn feeds inflation, decreasing real rates further still.

The naïve expectation would be that the Fed needs to raise nominal interest rates from zero to about seven percent to return to zero real rates. That is undoubtedly too extreme an expectation, but it is not an entirely ridiculous one and is likely of the right order of magnitude. Perhaps inflation will ease on its own by a percent or two. Perhaps negative real rates of a percent or two are tolerable. Even then, nominal short-term rates in the range of 3 or 4 percent are a plausible possibility in the near future.

The word from the Fed that theoretically reduced the value of the US stock market by about a twentieth was a hint that they might raise rates by 0.25% as many as four times in 2022. That, or something like it, may very well happen. But much more dire outcomes are also possible, something that does not seem to be in the calculations of most investors.

The Market Sentiment Framework

We use our Market Sentiment Framework to adapt the mechanics and weightings of our full quantitative models to changing market conditions.

The Sentiment Framework gauges the current state of market psychology on two dimensions. Efficiency measures the crowdedness of the market, the volume of participants seeking investment opportunities. Lower levels of efficiency imply more market mispricing. Optimism measures the willingness of investors to take on risk in exchange for distant and uncertain rewards. Higher levels of optimism imply a better outlook for risky asset classes.

Both the Optimism and Efficiency levels were nearly unchanged in January, and have remained in a narrow range for several months.

Optimism began the month at -0.02 and ended at -0.19. Although it decreased modestly during the second half of 2021, Optimism is well above its pandemic lows and not that far from its post-COVID high of 0.70 seen in mid-April of last year.

Efficiency fell slightly, starting the month at -0.41 and ending at -0.50. Efficiency continues to be comparatively low as compared to historical averages, which suggests a market that is still under stress.

Both measures are higher than where they were in early 2020, but have trended lower since spring 2021. The current positioning of the Sentiment Framework implies a market that is functioning less than ideally, with modestly optimistic but still fearful investors. This would imply a positive but challenged outlook for the market as a whole, but possibly an opening for value strategies to find opportunities.



The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes, and opinions of others are assumed to be true and accurate however 3D Capital Management, LLC (3D) does not warrant the accuracy of any of these. There is also no assurance that any of the above are all inclusive or complete.

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