How Much Does Fed Have To Tighten To Cause Stock Market Downturn?

by: John M. Mason

Summary

Market participants seem to be quite confident that the Fed will raise its policy rate this December, as it raised the rate in December 2015.

The December 2015 increase was a move to "save face" because of all the broken promises that Fed officials brought on the markets during 2015.

Not much will happen to the stock market if market participants believe that the Fed is no more determined to raise rates further in 2017 than it was in 2016.

It looks as if the Federal Reserve is going to raise its policy rate of interest this December.

Since the stock market seems to be so dependent upon Federal Reserve largesse, the fear is that a rise in the Fed's policy rate will cause the stock market to sink.

The Federal Reserve seems to be preparing its balance sheet, much as it did last year, in anticipation of such an increase actually happening.

From the middle of October last year, up to the December meeting of the Fed's Federal Open Market Committee meeting, the Fed drained excess reserves in the commercial banking system to "tighten up" just a bit so that the market would be more receptive to such an increase.

This "tightening up" did not seem to make any major impact on the stock market during this time as the S&P 500 stock index rose from 1,994 in the middle of October to 2,073 at the time of the December FOMC meeting, an increase of just under 4.00 percent.

The market just did not seem to believe that the Fed would actually raise the rate.

Many analysts have argued that the Fed had to raise the rate in December, just to maintain "face".

After the increase of 25 basis points took place in the middle of December, Federal Reserve officials began giving the market some "forward guidance" about the possibility of further increases in the rate in 2016.

The signal was that the market should expect at least two more increases in 2016, more or less evening spaced throughout the year.

From the S&P 500 index high of 2,078 by the end of the year, the index dropped to 1,880 in the middle of January, to 1,829 in the middle of February.

And, we entered into another year, very similar to 2015, when Fed officials gave indication of a rise in rates, only to be followed by a backing off when the time came to actually vote on a raise.

The volatility of the stock market picked up.

Now, we are in October of 2016 and the Fed is giving more signals that there will be a rate increase in December. These signals began in earnest once the September FOMC meeting ended.

Officials began to talk more about such an increase and the futures market indicated that market participants believed that there was a probability of about 0.67 that the Fed would raise the rate in December.

The minutes of the September 20-21 meeting seemed to indicate that such a rise might take place.

This year, however, the stock market did not increase as it did last year.

On September 22, the S&P 500 stock index closed at 2,177.

Since then, the market has tended to decline…modestly. At the close of business on October 12, the S&P closed at 2,139, down roughly 1.7 percent from the September date.

One could argue that market participants have a little more belief that the Fed will actually raise the rate in December, much as it did last year. Again, many analysts believe that the Fed will raise rates in December, as in 2015 it felt it had to move in order to save "face."

Market participants in other areas seem to be taking a rate rise seriously.

The value of the US dollar has declined substantially since the September meeting of the FOMC. For example, it took $1.1253 to buy one Euro on September 23. On October 12 it took 1.1006 to buy one Euro, a decline of 2.2 percent.

Furthermore, Treasury yields rose during this time as well. For example, the yield on the 10-year US Treasury note rose from 1.619 percent on September 22 to 1.770 percent on October 12. This represented a rise of 9.3 percent.

The question that is outstanding is "how much will the stock market decline if the Fed really goes ahead and raises its policy rate at the December meeting?"

The answer depends upon whether or not market participants believe that the Fed will raise rates any further in 2017 or will it revert to the behavior it exhibited in 2016 once the December 2015 rate increase was in place.

If the market believes that the Fed is moving toward December 2016, just as it did in December 2015, to save face by raising its rate, but will then revert back to the way it behaved in 2015 and 2016, then there should not be too much of a correction.

Connected with this is the rising presence of Board Governor Lael Brainard, who is getting all kinds of favorable press these days, not only because of her "dovish" approach to the policy issues, but is also becoming the subject of rumors pertaining to the possibility that if Ms. Clinton is elected the president this fall, Ms. Brainard might become US Secretary of the Treasury.

It is also notable that Ms. Brainard got the call to give the last speech by a Fed official before the September FOMC meeting, a speech that convinced the market that there would not be an increase at that meeting.

The alternative is for market participants to believe that the Fed will raise its policy rate in December…and, then will make two, or three, or four more increases in 2017.

If market participants come to believe this then the market, I believe, will have a substantial fall.

I really don't see this latter scenario happening. I don't believe that Federal Reserve officials have that much confidence in what they are doing and have little or no confidence in what is going to happen. They will, therefore, continue to muddle along with little or no leadership.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.