How Policy Uncertainty May Have Caused Latest U.S. Correction

Last week, the S&P 500 officially entered correction territory—again—down 10% from its Sep 2nd peak, while the Nasdaq has fallen even further, down nearly 12%. Meanwhile, long-term Treasury yields have edged higher, providing little of the diversification benefits that many investors may have been expecting from government bonds.

Why are we seeing this slide? Policymakers, from the Federal Reserve on down to legislators, can claim some credit for providing the stimulus that helped the market stage an unprecedented comeback after the COVID-19 bear market earlier this spring; but that means they also must shoulder the responsibility for the inaction that has contributed to recent declines. Unless the gridlock ends, investors can expect volatility to remain high over the next two to three months, with the fragile U.S. economy weakening further.

Here are three critical policy disappointments: 

• A new stimulus bill has stalled. Surprisingly, Senate Republicans have apparently walked away from the possibility of further fiscal stimulus this calendar year. Almost every Wall Street analyst, myself included, had expected another round of spending that would help state and local governments, support key industries and provide aid to small businesses and the unemployed.

Improvements to the labor market have slowed since early August. New unemployment claims are averaging close to 900,000 a week and millions of job losses once seen as temporary are becoming permanent. Consumer confidence has been lagging stock market performance for months, but prior economic stimulus had helped keep family finances afloat. Now the reality of economic pain may just be starting to bite

• The Fed has yet to provide further details on how its new plan for “average inflation targeting” would work, or how it will eventually roll back or taper the massive quantitative-easing stimulus programs put in place during the crisis. Instead, the Fed has only confirmed that it will keep the key federal funds rate near zero for at least the next three years.  That signaling has contributed to an all-time low in interest-rate volatility and moderately higher long-term yields.

One side effect of those higher Treasury yields: Tech stocks, often viewed as higher-risk growth investments that tend to trade at a given premium above the benchmark 10-year Treasury yield, now look even more expensive. That’s likely one reason tech stocks have been hit particularly hard lately.