The Stock Market And The Federal Reserve

by: John M. Mason

Over the past eight years, the performance of the stock market has been closely associated with the support given it by the Federal Reserve's monetary policy.

The big issue on the table right now is what will the Federal Reserve do in the future, will it change its focus moving into 2018 and 2019?

A lot of things contribute to this uncertainty, new Federal Reserve leadership, even beyond the newly-minted Fed chair; fiscal spending and greater deficits; and the value of the dollar.

The stock market hates uncertainty.

Over the past eight and one-half years perhaps the most certain thing in the world for the investment community was the Federal Reserve. And, the stock market benefitted from it.

Ben Bernanke became Fed Chairman bearing the reputation of one of the best scholars in the world when it came to understanding the Great Depression in the United States.

As the Great Recession proceeded in the United States, Mr. Bernanke conducted a monetary policy based upon his broad and deep knowledge of the earlier turmoil. During the recession, Mr. Bernanke led the Fed into a policy of “throw everything you can against the wall and see what sticks!” The downside risks were too great to take a chance on not stopping the downward spiral of the economy.

Once the economy turned around, Mr. Bernanke’s leadership focused upon creating a “wealth effect” in the economy so as to produce a strong recovery in the consumer sector. His research indicated a strong relationship between a wealth effect, whose foundation was rising stock prices, and consumer spending.

And, so the recovery proceeded based upon strong consumption expenditures.

Three rounds of quantitative easing highlighted an economic recovery based upon consumption spending but without a strong bump from spending on physical capital. But, the recovery was there and it was sustainable.

Janet Yellen followed Mr. Bernanke as the Chair of the Board of Governors of the Federal Reserve and continued his program, focusing particularly upon confidence that the Fed’s monetary policy, if anything, would err on the side to too much ease, avoiding any mistake on the downside.

Quantitative easing ended in October 2014 under the leadership of Ms. Yellen and an effort was made to return short-term interest rates, which were near zero in the United States, to a more normal level. Ms. Yellen’s leadership was calm and consistent, and underscored market confidence that the Fed would continue to err on the side of too much monetary ease, essentially writing a “put” to protect stock prices from declining.

The investment community bought onto what these two leaders were trying to do and, as I have written many times over the past eight years, have acted on this confidence to underwrite more and more new stock market highs.

The only time stock prices seemed to waver in the past eight years was when some event caused investors to pause and re-confirm the Fed’s commitment to supporting the stock market. And, this continued to be the case, even as Mr. Trump came to assume the position of President of the United States.

Again, as I have written many times over the past year, the stock market continued to produce new historic highs on the basis of Federal Reserve policy and some optimism that Mr. Trump might add some tax relief or infrastructure spending that would get the economy growing just a little faster than the 2.1 percent, compound annual rate of growth of the full recovery up to the present time.

Now, the situation has changed. I won’t place the blame for the stock market’s decline last Friday and this Monday on the departure, but it is highly ironic that stock prices experienced such a decline surrounding Ms. Yellen’s leaving.

But, we do have a new Fed Chair, Jerome Powell, and will have almost a completely new Board of Governors of the Fed. Mr. Powell has been with the Fed for several years and becoming a member of the Board of Governors in May 2012. He has voted solidly with Ms. Yellen and is expected to continue on the monetary policy that has been followed in recent times.

However, the times have changed and the monetary policy of the previous eight years may not be the appropriate one for the next month, the next quarter, the next year, and so on. And, with an almost completely new makeup of the Board of Governors, the outcome of policy discussions in a new environment is subject to substantial uncertainty.

Where will the Fed be in the near future?

And, then the Fed is facing a new fiscal policy with the tax reform bill passed last December, new forces are at work in the economy. Not only will spending be increasing, which could have an important impact on raising inflation, there is a substantial increase in the government’s budget deficits coming in the near future. Furthermore, an infrastructure bill that might add another large chunk of debt on the table might even make future Fed policy construction totally uncertain.

Financial markets have reflected the potential impacts of these spending places and deficit increases. The bond market has been especially impacted by all these budget plans and the uncertainty about how they will be financed.

In particular, the yield on the 10-year US Treasury note rose due to this turmoil and moved through the market’s recent turning-point of 2.66 percent. As of today, the yield is around 2.80 percent with a feeling that a higher rate will be forthcoming in the near future. The reason given for this rise is an increase in inflationary expectations.

In addition, the value of the US dollar has been falling in recent weeks with the cost of a Euro approaching $1.25 when this value was closer to $1.05 a year earlier.

How is the Federal Reserve going to react to these events?

Many analysts are concerned that the Fed will move its short-term interest rate up faster than the three increases that have been signaled for this year. Faster movements would be to begin the fight against higher inflation rates and the temper the weakness of the US dollar.

If these other targets take over the Fed’s attention, then the monetary policy guidance for the next year might be substantially different from the one that has existed over the past eight. If so, then investors in the stock market and, possibly, stop relying upon the Federal Reserve to support stock prices. Wow!

What could this mean? Well, as I have written about constantly, using indicators like Robert Shiller’s Cyclically Adjusted Price Earnings ratio (NYSEARCA:CAPE) the stock market could be considered to be over-priced. The CAPE measure in January exceeded the peak it reached before the stock market crash in 1929 and is only exceeded by the peak it reached in 2000 before the stock market decline of 2001.

Note that the value of the CAPE measure says nothing about when a decline might take place, just that on a historical basis CAPE will revert to the mean sometime in the future.

There has been a high correlation between the CAPE measure and Federal Reserve monetary support over the past eight years. There is currently a great deal of uncertainty over what Fed policy will be in the near future, and how stock market prices might react to this change.

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.