Money Sage (archive)

This post is intended to address the issue of the relationship between FED easing cycles and stock prices. It is NOT intended as a comprehensive analysis of the relationship between FED policy and stock prices.

There is a very clear relationship between FED easing cycles and stock prices. Easing cycles, in DUE COURSE, boost stock prices. The enhancement of stock prices fostered by FED rate-cutting is variable, but it has been positive on all occasions save one, insofar as we are aware. The rate cutting cycle generates a bull move in stock prices for several reasons.

Generally, the market performs its function as a leading indicator of the economy. The FED, in contrast, is generally RE-ACTIVE to economic developments, which are a LAGGING CONSEQUENCE of prior FED monetary policy. In plain English, the normal sequence is as follows:
(1)The FED raises rates and drains liquidity from the financial system as the economy heats up and inflation fear at the central bank ascends;
(2)The market falls, pricing in a sequence of rate hikes, the bulk of which HAVE NOT YET OCCURRED. Moreover, the market prices in the weaker economy and softer corporate earnings which normally attend and follow the rate-hiking cycle;
(3)The FED transitions from the tightening cycle to the accommodative stance; the market rallies, either before the first rate cut or in the early part of the rate-cutting cycle. It prices in at least part of the sequence of rate cuts which HAVE NOT YET OCCURRED. Having already discounted the weakening economy over the next several quarters, it now begins pricing in the economic improvement and rise in corporate earnings which the initial rate cuts imply 9-12 months down the road.
(4)The FED continues cutting rates and injecting liquidity into the banking system; the market rally continues, as fearful fence-sitters start to buy, driven by the need to secure better yields as fixed income rates fall. Confidence rises and buying accelerates.

The one episode of rate-cutting and liquidity expansion which was accompanied by a BEAR MARKET was the case of the 2000-2002 BEAR MARKET. In this case, the prior rate-raising cycle burst the equity market bubble. The market kept declining until valuations -- which had reached the highest levels in American history in early 2000 (i.e., at least DOUBLE the prior peak valuations )came down to earth. Only then did the stimulative impact of declining interest rates have their normal stimulative effect on stock prices.

The 1929-1932 equity bear market, by contrast, received NO HELP from the FED. The FED DID NOT adopt an accommodative monetary policy during that period. In fact, it passively observed a drastic contraction in the money supply, and the attendant spread and deepening of economic weakness, which ultimately developed into the greatest economic depression in American history.

The current monetary situation does, unfortunately, still retain an element of ambiguity. Generally, the FED has adopted a more accommodationist stance than hitherto. It is cutting rates and making efforts to provide emergency liquidity to the banking system. However, the persistence of an obsessive fear of inflation has deterred the central bank from flooding the financial system with liquidity.

As we have stated repeatedly in the past, we believe the FED's reluctance will fall before the intense and irresistible pressure of the financial markets and of the politicians in an election year. Consequently, we expect the usual beneficent effect of an accommodationist monetary policy on the equity market. That this impact has thus far been delayed reflects the FED's half-heartedness in supplying liquidity.

We do not believe that the forthcoming market experience will differ from past bull moves which have developed in consequence of FED easing cycles. However, the folk on Constitution Avenue may require that the markets and the politicians turn up the heat a few more notches before they fold.