A Market Selloff Triggered By A Fed Policy Error
The Fed made a significant policy error last week by deciding not to cut the Fed Funds rate and the stock market is now responding to that error via the selloff we have seen over the past week. Unfortunately, this policy error is nothing new. Throughout history, the Fed typically waits too long to begin reducing interest rates after inflation has already abated and they seem to be on that path again.
The Fed made a significant policy error last week by deciding not to cut the Fed Funds rate and the stock market is now responding to that error via the selloff we have seen over the past week. Unfortunately, this policy error is nothing new. Throughout history, the Fed typically waits too long to begin reducing interest rates after inflation has already abated and they seem to be on that path again.
The Fed’s primary objective is to create an economic environment with full employment and inflation in a range of 2% to 3%. The Fed's primary tool to achieve these objectives is the use of the Fed Funds rate, which has a dramatic impact on interest rates within the economy. When the economy runs too hot, the Fed raises interest rates to slow it down. When the economy begins to contract, the Fed lowers interest rates and makes lending more attractive to get the economy going again.
Think of the economy like a campfire; the Fed is the campfire attendant, and they have three tools at their disposal:
Logs
Gasoline
Garden hose
When the economy is growing rapidly, the fire can get too big and risks getting out of control. When that happens, the Fed can use the garden hose (raising interest rates) to dampen the blaze. Over the past 18 months, the Fed has raised rates to reduce inflation from the peak rate of 9% to the current rate of 3%.
Their use of the hose has also caused the labor market to soften which can be seen in the reduction in the rate of non-farm payroll gains:
It can also be seen in the recent rise in the unemployment rate (grey line) and the steady decline in wage growth (blue line):
While the Fed has successfully tamed the inflation blaze, it now runs a new risk: the fire going out completely, which results in the economy slipping into a recession.
As the fire dies down, the Fed's job is to add logs to the fire via interest rate cuts to keep the fire from going out completely.
Last Wednesday (July 31, 2024), the fire was at a level that it needed a log, but the Fed decided not to add one, and the stock market responded accordingly. The Fed does not meet again until September 17th, which is almost seven weeks away. They now run the risk that the fire gets too low before reaching that September meeting.
But there is also another risk that the market is digesting: if the fire does get too low or goes out before the September 17th meeting; for anyone that has ever used too much water on a fire, it can take a while to rebuild the fire. Meaning, if the Fed does wait until the September meeting to reduce interest rates by 0.25% - 0.50%, it historically takes 4 to 6 months before that decrease in interest rates has a positive impact on the economy, and that 4 to 6 month wait is usually ugly for the equity markets knowing that help is on the way but it’s not here yet.
If the recent market selloff escalates, I think there is a good chance that the Fed may need to step in before the September 17th meeting and announce a rate cut to calm the markets. While it may be viewed as an act of desperation to keep the economy from slipping into a recession, in my opinion, it’s something that should have already happened. It’s only logical that if inflation is in a safe range and trending downward, and labor markets are showing the same trend line of softening which they are, a 0.25% rate cut, at a minimum, is warranted given the fact that the rate cut will not have its positive impact for another 4 – 6 months.
Unfortunately, throughout history, the Fed has been late to both sides of the game. They typically wait too long to raise rates, which gave us the 9% inflation in 2022, and they historically wait too long to cut rates, which is why there has historically been turbulence from the equity market on the backside of Fed rate hike cycles.
If the Fed either steps in before the September 17th meeting to lower rates or if the economy can stabilize between now and the September meeting for a potentially larger rate cut from the Fed, markets may stabilize in the coming week, however, investors also have to be ready for an escalation of the current selloff and increased levels of volatility as the markets try to maneuver through the late-innings of the Fed’s tightening cycle. Otherwise, the economy could slip into a mild recession that so many economists were predicting in 2023 that never happened, and then the Fed will be forced to use gasoline on the fire via a series of rapid large rate cuts and/or direct injection of liquidity (bond buying).
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
Coronavirus & The Market Selloff
Today was a wild ride for the stock market. The Dow Jones posted a loss of 1,031 points on February 24, 2020 as fears of the continued spread of the Coronavirus sparked a selloff in the stock market. Over the past 24 hours, we've
Today was a wild ride for the stock market. The Dow Jones posted a loss of 1,031 points on February 24, 2020 as fears of the continued spread of the Coronavirus sparked a selloff in the stock market. Over the past 24 hours, we've received the following questions from clients that I want to address in this article:
Why is the market selling off on this news?
Do you think the selloff will continue?
Should you be moving money out of stocks into bonds?
Why Is Market Selling Off On This News?
You have to remember that the stock market is made up of individual companies. Each company’s stock price is just an educated guess by investors as to how much those companies are going to make in profits over the next 3 months, 1 year, 5 years, and beyond. Unexpected events like the Coronavirus create large deviations between those educated guesses and actual results.
In the case of the Coronavirus, it’s disrupting the revenue stream of many companies that produce and sell goods across the globe. For example, Nike receives 17% of its revenue from China, and the company has temporarily closed more than half of its stores in China. The stores that remain open are operating on abbreviated hours. If the stores are not open, then they can’t sell Nike shoes and apparel, which will most likely cause Nike’s Q1 revenue to be lower than expected. That in turn could cause the stock price to drop once the Q1 earnings report is released later this year.
But it’s not just Nike. The S&P 500 Index is made up of a lot of companies that sell goods in China and other locations around the world: Apple, Yum Brands, McDonalds, Proctor & Gamble, and the list goes on. Beyond just retail, you have airlines, hotels, and casinos that are being negatively impacted as people cancel travel plans and vacations. The point I’m trying to make is there are real business reasons why the stock market is reacting the way it is, it’s not just displaced fear.
All of these companies are trying to figure out right now what the impact will be to their revenue. The next question then becomes, how much are these companies going to miss by?
Do You Think the Selloff Will Continue?
That leads us into the next questions which is “do you think the selloff will continue?” Historically, contagious disease outbreaks have been quickly contained, such as the SARS outbreak in the early 2000’s. The amount of damage to the markets seems to be highly correlated to the amount of time it takes to contain the outbreak. The longer it takes to contain the outbreak, the longer it takes people to return to work and to return to their normal spending habits. The news broke this morning that there are new confirmed cases of the Coronavirus in Italy and South Korea which makes investors question whether or not the threat has been contained.
Unfortunately, there is no solid answer as to how long the current selloff might last. It could end tomorrow or it could continue off and on over the next few weeks. But it’s important to remember that even though market events like the Coronavirus do impact the short-term profitability of companies, it’s less common that these types of events impact the long-term performance. When you have a selloff sparked by a single market event versus a full blown recession, it’s not uncommon for long term investors to start stepping into the market and buying stocks at these lower levels.
Should You Be Moving Money Out Of Stocks Into Bonds?
This bring us to the final question, should you be making changes to your investment portfolio based on today’s market events? In my opinion, the answer to that is “no” but I think there is a lesson to be learned for investors that are still overweight stocks in their portfolio. Over the past year, the stock market has appreciated rapidly in value but the growth rate of corporate earnings has lagged behind. When this happens, stocks start to become overvalued, and the market becomes more vulnerable to selloffs.
This week the selloff was sparked by the Coronavirus, a few months from now it could be fears surrounding the elections in the U.S., trade, or some other geopolitical event. When you enter the later stages of an economic expansion, volatility, which has been largely absent from the U.S. stock market over the past few years, becomes a common place. Investors that have elected to stay overweight riskier asset classes in the later stages of this economic cycle, need to make sure they have the risk tolerance and discipline to weather these market selloffs.
Michael Ruger
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
