In a recent post I noted, “…barring a consequential decline in asset prices, I believe the Federal Reserve will be forced to continue increasing rates and unwinding their bloated balance sheet.” While I did not have a number in mind when I used the word “consequential”, I certainly didn’t believe a flat YTD number on the S&P 500 would cause the Fed to alter their plans. And that, of course, is what markets were led to believe yesterday after Jerome Powell stated the funds rate is “just below” the Fed’s theoretical neutral rate.
Now that we have a better understanding of the Federal Reserve’s tolerance for financial instability (not much), I believe investors are in a better position to gauge future policy responses related to further declines in equity prices. I put my best guess together in the Federal Reserve Cheat Sheet below:
S&P 500 YTD Policy Response
5%+ Gradually raise rates
+5% to -5% Hint at a pause
-5% to -15% Pause
-15% to -20% Hint at rate cut/ending QT
-20% to -25% Cut rates and end QT
-25% to -30% Hint at QE4
-30% or worse Implement QE4
Source: Conversation with myself on the way home from grocery store
Margin of error: +/- a lot
So there you have it. Of course this is just a wild guess from an unqualified guesser of monetary policy. And I’ve certainly been wrong in the past. In fact, before yesterday I thought Chairman Powell might be different. Not Paul Volcker different, but possibly less willing to backstop the financial markets relative to Greenspan, Bernanke, and Yellen. However, after yesterday, I’m now leaning towards more of the same. And I suppose I can’t blame him. Powell inherited a tremendous amount of asset inflation. Similar to a banker with a large book of loans, no one wants to see the loans go bad on their watch (especially if they weren’t the underwriter).
I also believe the recent decline in certain commodities is providing the Fed with some cover to pause. In fact, it’s beginning to feel a little more like 2015-2016. It will be interesting to monitor the impact from the recent decline in energy prices. Similar to the last decline in 2015, will we have another earnings recession? And let’s not forget the high yield market and credit spreads. As can be seen in the charts below, energy prices, along with the health of the energy industry, can have a considerable effect on the economy, the credit markets, and earnings growth.
2018 is turning out to be a very interesting year — there are many important variables in motion influencing the profit and market cycles. I’m looking forward to analyzing Q4 2018 corporate operating results to learn more. In the meantime, I’m currently in the process of reviewing recent quarterly results of many of the consumer businesses I follow. I should have an update soon, providing timely information on the health of consumer businesses and trends in consumer spending.