Will the Fed keep riding to the rescue of equity markets? You bet

Oh dear, oh dear. US CPI for January reported in along the seven-month-old continuous declining trend which is good but still, at 0.5%, month over month, and 6.4%, year over year, higher than economists’ consensus forecasts which, alas, is bad. Either way, the starry-eyed monetary policy easing merchants were caught wrong footed and by the end of the day the media’s slogan with respect to the US interest rate trajectory had once again become “higher for longer”. And yet, equity markets in America closed showing nothing more than modest losses. The Dow closed at 34,089.27 pts or down by 0.46%, the S&P500 at 4,136.13pts, off by 0.03% which is as good as unchanged and the Nasdaq, behold, closed at 11,906.15 pts which was in fact 0.57% to the good. The VIX index which measures the volatility of the S&P and is known colloquially as the Fear Index actually fell by 1.43 pts to 18.91. What, one cannot but wonder, has got into these guys?

The dichotomy between bond and equity markets on Tuesday grew more and not less pronounced as the equity geeks apparently continue to believe that Nirvana is just around the corner and that somehow – not in my opinion a new phenomenon – the Fed will eventually be there to ride to their rescue. In a way I can’t blame them as for most of the past two and a half decades that is exactly what it has done.

Some of the older readers will remember the morning of 6 December 1996, the day after Fed Chairman Alan Greenspan had addressed the Economics Club of New York and in which he coined that immortal phrase about “irrational exuberance” of stock markets. This was the end of 1996 and panic struck that the Fed was about to direct monetary policy towards slowing the inexorable rise of the dot.com phenomenon. And what did the Fed end up doing? Nothing. Nought. Nada. The dot.com thing went on and on and the burst did not follow until March of 2001. Yes, the Fed in general and “Greenie” in particular were equity investors’ best friends.

The second proof that stock markets were important to the central bank followed in the aftermath of the “9/11” attacks on New York and Washington. I know I keep on harping back to the events following the downing of the Twin Towers but I do believe that it was at the end of 2001 that the monetary policy die was cast. It has determined the way in which markets, especially the ones in which equities are traded, act and think. In late 2001 the US economy was on its way into a cyclical downturn. We all knew that economies go up and down, that there is a sort of seven-year boom and bust rhythm and that recessions are healthy in a Darwinian sense as they flush out the weak and create light and breathing space for new enterprises. In September 2001 that all changed.

America was truly rattled by the “9/11” terrorist attacks. Pearl Harbor of December 1941 had been a tremendous and to most Americans an entirely unexpected and unprovoked assault on the nation’s pride but it had happened a long way away and not on American soil. Hawaii, by the way, did not in fact gain statehood until 1959. But the September 2001 events hit the heart of the US mainland and in the nation’s two most important cities to boot. I’m not sure how many, even those old enough to have been in the middle of it all, can remember just how far the entire country had gone into total spasm. Talk was of a country and its people in deep PTSD and the imminent risk of the economy throwing itself off a cliff. Greenspan knew that he could do nothing to unmake the events of that dreadful day but he could, if he acted fast enough and decisively enough, prevent the economy from committing ritual seppuku. Thus, he opened the monetary policy taps and, behold, the economy survived and in subsequence even thrived.

Enough has been written about what followed for what had begun as an emergency rescue action developed into the credit boom which in turn went sour and in 2007/2008 and ended in the GFC, the Global Financial Crisis. But a new monetary policy paradigm had been created which determined that at the first sign of a slowing economy the Fed would slash rates and in doing so protect the interest of shareholders. Call the macro right and you call the Fed right. Call the Fed right and trade stocks that way. Sod single stock selection, just trade the index. And best trade the index not in the futures and options market but in retail targeted bite sizes, best reflected in ETFs. All this worked to perfection as long as the financial markets were two dimensional and binary. Inflation, remember, was something that only existed in history books. Inflation – and I don’t include anything below 2% – was a bit like sex amongst teenagers. Everybody talked about it but nobody had actually experienced it.

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