While it is probably not a primary objective of the Federal Reserve to boost stock prices, the investment community seems to hold the view that current Fed activities can influence equity prices in the near future much more than it is reasonable to expect.
Historically, falling Fed rates have preceeded, on average, rising stock prices. The time periods of rising prices are experienced for many months (and even years) after the first rate cut. However, there are times when the delay from the first rate cut to rising stock prices is very long. The most recent example is the current bull market which just ended. It started in the fourth quarter of 2002, well over a year after the Fed started cutting rates.
The latest three day bounce in the stock market is not likely to last. This week the Fed meets and the futures markets have priced in the expectation of an additional 50 basis point (0.50%) discount rate cut. What will actually happen is up in the air, in my opinion. The Fed is really on the spot. I have a most likely market response scenario for each potential Fed action:
1. The Fed raises rates this week. I believe this is an impossiblity.
2. The Fed takes no action this week. The market will sell off sharply with much handwringing over an unresponsive Fed being “behind the curve”.
3. The Fed lowers by 25 basis points. The market will sell off, but probably not as sharply as in 2. There will be the same handwringing as in 2.
4. The Fed lowers by 50 basis points. This is what is expected by bond traders. In my opinion, the probability is 50/50 (pardon the pun) or less. If this happens the market may have a short rally (possibly only minutes) and then start drifting lower again. The investor psychology will be dominated by a fear that maybe things are even worse than they thought because the Fed has cut the discount rate by 1.25% in a week’s time.
5. The Fed lowers by 75 basis points. This is quite unlikely, in my opinion. If it were to happen, the response would be similar to 4. for the same reasons.
6. The Fed lowers by more than 75 basis points. I believe this is impossible.
My view is that whatever the Fed does this week will produce little benefit for stocks. We still have the weight of unwinding all the complex financial derivatives that were developed over the past five years. We still have the uncertainty of what the balance sheets really are for the major banks. We still have a slowing GDP growth rate – some think it may already be negative. We still have consumers squeezed by record credit card debt, rising variable rate mortgage contracts, falling home values and concerns about keeping their jobs. With consumer spending accounting for 2/3 of our GDP, our economy is struggling. Stocks will not put in a bottom until there is hope that all these negative factors will turn up within 3-6 months. We are not there yet and may not be until late this year.