Forget about the Fed decision
Tomorrow is Fed Day (again). And as every time the Fed decides on interest rates, investors will pour over both the actual change in Fed Funds Rates and the guidance given by Jerome Powell and his colleagues. But I may argue that whatever the Fed decides to do today is completely irrelevant. Instead, all we need to do is look at what the Fed intends to do in the future. Words speaker louder than actions when it comes to the Fed.
When the Fed started its rate hike cycle, investors often told me that the stock market will not bottom until the Fed has started to cut interest rates. It wouldn’t be enough for the Fed to just stop hiking because historically, that wasn’t enough to keep the US stock market from falling further. Indeed, going back to 1954, the S&P 500 dropped on average another 17.5% after the last rate hike before it could find a bottom. The perceived wisdom was that investors need to wait for the Fed to actively start cutting rates before it is worth buying stocks again.
Fed Funds Rate and stock market bottoms in the past
Source: Bloomberg
My argument against this was always that this may have been the case in the past, but since the financial crisis in 2008 the Fed and many other central banks have switched their policy to forward guidance. And this has made the chart above obsolete because what the stock market now reacts to is the guidance of the Fed, not what it actually decides on interest rates. Stock markets are forward looking and thanks to forward guidance, they have become even more forward looking when it comes to monetary policy.
Take a look at the chart below. It shows the correlation between the S&P 500 in the two weeks after a Fed decision and change in Fed Funds Rates as well as the change in expected Fed Funds Rates in the future.
Correlation between S&P 500 and Fed decision
Source: Bloomberg
Before the financial crisis the correlation was highest between the S&P 500 and the actual change in Fed Funds Rates announced by the Fed. The correlation between the S&P 500 and anticipated Fed Funds Rates in nine- or twelve-months’ time was essentially zero.
But since the end of the financial crisis, the picture has completely changed. Now, the correlation between the S&P 500 and the actual change in Fed Funds Rates is zero, but the correlation with expected Fed Funds Rates in nine or twelve months from now has increased a lot.
And unlike the Fed Funds Rate, the expectations for the Fed Funds Rate twelve months in the future has peaked in January and is already pricing in potential cuts. If you ask me, the bottom in the market is already in and waiting longer to buy stocks is likely to cost you money in the form of missed returns.