In 1913, Congress created the Federal Reserve to “provide the nation with a safer, more flexible, and more stable monetary and financial system.” It is 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 markets hanging on every word or action coming from the Fed, it begs two questions: Has the Fed become beholden to the markets? Have markets become too dependent on the Fed?
While the answers to these questions are up for debate among academicians and market gurus, the mere discussion highlights a challenge for today’s investors: Things that traditionally influenced markets, such as company earnings and growth prospects, now tend to be overshadowed by the Fed – what the Fed says or doesn’t say – what it does or doesn’t do. It seems that the Fed is now studied as though it were a Fortune 500 company!
The Fed’s influence on the markets isn’t a new phenomenon. It might have started with the now-famous “irrational exuberance” speech in 1996 by then Fed Chairman Alan Greenspan. But the financial crisis of 2008 is what really seemed to cement in traders’ minds the notion of the Fed as a protector of the markets. Why is that?
The U.S. financial sector, as represented by finance, insurance, real estate, rental, and leasing, represents 20% of U.S. GDP. The financial sector is one of the largest contributors to GDP growth, big enough to influence monetary policy. When central banks, such as the Fed, steered the world 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 is as though the Fed’s role has been taken to an extreme, as the solution to all that ails the stock market.
It is no surprise, then, that in the days leading up to the Fed meeting that ended on July 31 stocks barely moved as traders waited with bated breath to see what the Fed would do. Market participants widely expected the Fed Funds rate to be lowered by a quarter point, the first rate cut in a decade. While the Fed followed through with the expected rate cut, the commentary by Fed Chairman Powell that followed was not what the stock market wanted to hear. While traders expected Chairman Powell to usher in a shift in Fed policy with future rate cuts, the chairman indicated the opposite: no shift in policy and no guarantee of further rate cuts. This action was more of a mid-cycle adjustment rather than a longer-term change of direction. Consequently, the stock market signaled its disappointment with a knee-jerk reaction to the downside.
Why Would the Fed Lower Rates Now?
With a growing U.S. economy, the U.S. stock market at all-time highs, and no recession on the horizon, some questioned the need for any rate cut at all; some even argued for a rate hike. So what prompted the Fed to lower short-term interest rates?
According to Ned Davis Research, Fed rate cuts are more effective when the economy is nearing a recession, and first Fed rate cuts have historically spurred economic activity. So a rate cut now could be considered more of an insurance policy against any looming recession or a way to prolong the current economic expansion. What would have the Fed concerned? Global growth is slowing. The U.S. may be holding its own for now, but it would not be immune to a global recession.
Skeptics of Fed independence from politics and the markets might say that the rate cut at the end of July was simply the Fed throwing the market a bone, giving it what it wanted, but tempering expectations with the commentary that followed. Hence, the delicate dance between the Fed and the markets continues. In any event, we expect there could be additional fireworks in future meetings taking place in September and even December. Of course, we have the FSA Safety Nets® in place should that occur, and we are monitoring those daily.
Mary Ann Drucker
Assistant Portfolio Manager
Disclosures are available at https://fsainvest.com/disclosures/market-update/.