Gavin W. Stephens
Director of Portfolio Management
Director of Portfolio Management
Will declining stock prices cause the Federal Reserve to alter its course?
During the last hiking cycle—a slow, deliberate cycle that began in December 2015—investors behaved as if the Federal Reserve would not tolerate a meaningful decline in stock prices. If stock prices declined sharply, many believed that the Federal Reserve would either slow, or pause, its plan to raise interest rates to prevent stocks from declining further. This dynamic led to the concept of a “Fed Put,” or the belief that stock prices had limited room to fall, much like a put contract establishes a floor on the price of a financial security.
With stock markets falling, and the Federal Reserve beginning a new program of raising interest rates, does a “Fed Put” exist today?
History – Looking Back at Tightening Phases
Over the past 50 years, the Federal Reserve has not raised rates when stocks have been in bear-market territory (i.e., with S&P 500® Index down 20% from recent highs). However, the Fed has raised rates when stocks have been close to entering bear territory. The most significant stock market declines, in periods during which the Fed was raising rates, occurred in 1974 (-18%), 1973 (-15%), and 2018 (-14%). And unless we have a stock-market bounce within the next three weeks, an expected rate increase in June will join that list.
Since 1970, the Fed has raised rates eight times when stocks have been down at least 10% from recent highs. Additional periods, from those mentioned above, include 1977, 1984, 1999, 2016, and 2022. In all but one of these instances, inflation (as measured by the Consumer Price Index [CPI]) was either increasing or labor markets were strengthening. (1977 is the outlier.)1 And in four of eight cases, inflation was moving higher while labor markets were strengthening.
In sum, history shows that the Fed will tolerate large drops in stock prices if conditions warrant it. Those conditions are in place today, meaning that we should not expect the Fed to come to the stock market’s immediate rescue.
Theory – Why the Fed Is Unlikely to Flinch
The Fed has little influence over economic supply but can affect economic demand. The Fed does so through tightening or loosening financial conditions which, as Federal Reserve Chairman Jerome Powell has repeatedly noted, constitute “the mechanism” through which policy meets the economy.
Various indexes measure financial conditions and do so in different ways. The most prominent indexes, however, consider at least two primary elements:
When stock and bond prices are rising, financial conditions are looser, which supports economic demand. For example, higher stock prices can support demand by facilitating equity-related financing and supporting spending via the wealth effect. Declining stock and bond prices have the opposite effect by tightening financial conditions and weakening demand.
Financial Conditions Indexes – Conditions Are Loose But Tightening
Two indexes show that the Fed’s actions are already tightening financial conditions. Both indexes have moved up over the past six months.
The point of quantitative tightening (QT) is to tighten these conditions, which would lead to higher levels of these indexes. Lower asset prices facilitate this process. Rising asset prices do the opposite. This suggests that the market rally that followed Chairman Powell’s last press conference, which resulted in the largest single-day increase in the S&P 500® in two years (+3%), was not the result that Powell would have preferred. Rather, rising stock prices are somewhat at odds with the Federal Reserve’s objective to cool the economy and slow inflation.
In the eyes of the Fed, higher stock prices mean looser financial conditions. While investors define a good stock market as one in which prices are rising, the Fed defines a good stock market as one that is functioning properly, not necessarily one that is rising.
As former Federal Reserve official Bill Dudley wrote on April 6th, “Investors should pay closer attention to what Powell has said: Financial conditions need to tighten…. One way or another, to get inflation under control, the Fed will need to push bond yields higher and stock prices lower.”
Our View: Declining Stock Prices Are Unlikely to Deter the Fed
The current combination of an exceptionally strong labor market and excessively high inflation increases the likelihood that the Fed will stay the course on rate increases—even if the S&P 500® falls into bear market territory.
As Fed Chair Jerome Powell said on April 21st, “(Former Fed Chair) Paul Volcker knew that in order to tame inflation and heal the economy, he had to stay the course.” That statement indicates the Fed may be about to make history by raising rates after stocks enter a bear market.
But it won’t be easy. After all, the stock market is a leading indicator of the economy’s health. While the Fed seems poised to watch stock prices fall, they should not ignore them completely.
1 Direction of CPI is measured as six-month change in YoY headline CPI. Labor market direction is measured using the Sahm rule. Both measurements are as of month-end preceding a rate hike.
DISCLAIMER: The information provided in this piece should not be considered as a recommendation to buy, sell or hold any particular security. This report includes candid statements and observations regarding investment strategies, individual securities, and economic and market conditions; however, there is no guarantee that these statements, opinions, or forecasts will prove to be correct. Actual results may differ materially from those we anticipate. The views and strategies described in the piece may not be suitable to all readers and are subject to change without notice. You should not place undue reliance on forward-looking statements, which are current as of the date of this report. The information is not intended to provide and should not be relied on for accounting, legal, and tax advice or investment recommendations. Investing in stocks involves risk, including loss of principal. Past performance is not a guarantee of future results.
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