Has the Fed become beholden to the markets, and have the markets become too dependent on the Fed? In this month’s video market update, Mary Ann Drucker, FSA’s Assistant Portfolio Manager, explains the relationship between the Federal Reserve and the markets.
July Stock Market Update Transcript
Hello. I’m Mary Ann Drucker here with our video market update for August. When Congress created the Federal Reserve in 1913, it’s doubtful that anyone could have foreseen the extent to which the Fed and the markets would be intertwined 100 years later. In today’s environment, with the markets hanging on every word or action coming from the Fed, it begs two questions: Has the Fed become beholden to the markets, and have the markets become too dependent on the Fed?
While the answers to those questions are up for debate, the mere discussion highlights a challenge for today’s investors. Things that traditionally influence markets, such as company earnings and growth prospects, tend to be overshadowed by the Fed.
Now the Fed’s influence on the markets isn’t a new phenomenon. One can look back to 1996 at the now-famous irrational exuberance speech given by then Fed Chairman Alan Greenspan, but it really wasn’t until the financial crisis of 2008 that traders began to look to the Fed as more of a protector of the markets. Now why is that?
Well, the U.S. financial sector, which is made up of finance, insurance, real estate, rental, and leasing, represents 20% of U.S. GDP, making it one of the largest contributors to GDP growth, and we’re part of a global economy. When central banks pulled world markets out of the Great Recession, world markets fell into a sense of security that central banks would take whatever action was necessary, not only to prevent a financial catastrophe, but to remove any speed bumps from economic expansions.
It’s no surprise, then, that in the days leading to the Fed meeting that ended on July 31st, stocks barely moved as traders waited to see what action the Fed would take. Market participants widely expected the Fed Funds rate to be lowered a quarter point, the first rate cut in a decade. While the Fed followed through with that expected rate cut, the commentary by Fed Chairman Powell that followed was not what the stock market wanted to hear. Consequently, the stock market signaled its disappointment with a knee-jerk reaction to the downside.
So why did the Fed lower short-term interest rates anyway? According to research by Ned Davis, Fed rate cuts are more effective when the economy is nearing a recession and first rate cuts have traditionally spurred economic activity. So a rate cut now could be merely an insurance policy against any blooming recession, or at the very least, it could dampen the severity of an economic downturn when and if it comes. The Fed is trying to counteract the effects of the trade wars and the fact that we’re in a slowing global economy.
Until next time, thank you for watching.