The Federal Reserve’s Role in the Stock Market

by Aaron Warby

For several months now there has been a lot of focus on Federal Reserve statements. The question in some investors’ minds is, “how much control does the Federal Reserve have over the stock market?” For the near-term and the likely over the next several years the Federal Reserve will be a major market influencer.

In broad terms the Federal Reserve has three major roles. The first is to provide liquidity to the United States government. The second is to set the prime interest rate which controls the lending interest rate for almost all other loans originated by U.S. banks. And the third is to control the trade value of the dollar against other currencies throughout the world. The combination of action between the government liquidity, interest rates and world currency strength influence the inflation rate.

Interest rates control the flow of money to business. If the rates are low, there is more incentive for a business to borrow money for projects like expansion or high yield investments. If, on the other hand, interest rates are high business expansion comes at a much slower pace and as this lack lust growth shows in the quarterly revenues, stock prices are also slow moving.

As for the trade value of the dollar on the world market, this also has a major effect on business growth in terms of revenues. As we live in a global business world and a good percentage of the large cap U.S. business revenues comes from overseas, the strength of the dollar can lead to increased or decreased overseas sales. A stronger dollar would mean that U.S. produced goods might become more expensive than locally manufactured goods and depending upon the price elasticity of the good being sold higher process generally mean fewer units sold and lower revenues. On the other hand, a weaker dollar means that U.S. produced goods would drop in price which could result in more goods sold and higher company revenues.

The importance of providing liquidity to the government is the function that has most affected the market. There are two functions of government liquidity that are in focus right now. The first and most often used since the establishment of the Federal Reserve is to purchase Treasury notes issued by the U.S. government in exchange for newly minted money. Soon the U.S. government will go into a structured shut down due to lack of funds unless congress can pass a new spending bill that will allow the government to issue new debt certificates called Treasury notes.

In the case that there is a government shutdown there could be further ripples of fear in the market causing further downward pressure. This government shutdown would not likely be a very big disrupter to the market as shutdowns have happened with enough regularity now that it is likely that most investors will make the logical assumption that any shutdown would be temporary, and little would change during the process of increasing the debt limit.

What will weigh heavily on the market over the next several weeks is the inability that congress has expressed in agreeing on a new stimulus plan. What the average citizen does not recognize is that the success of the eleven-year bull market that we have enjoyed is due, at least in part, to consistent government stimulus. From 2009 to March 2020 the government was using quantitative easing. During this pandemic, stimulus has been much more overtly used and is mostly responsible for the feelings of well-being among investors that allowed the markets to reach new highs during the worst recession since the Great Depression.

The point is that as the markets have been supported by government bail-out money in one form or another for 11 years. The thought that the tap could be turned off and especially at such a critical time could be devastating to the markets and have a larger effect on the direction of the market and the size of movement than the continued depressing economic reports. Already companies have indicated that without more stimulus money, and particularly Payroll Protection Program money, there will be a wave of layoffs, furloughs and bankruptcies that will result in higher unemployment and some stock failures.

However, if congress can find common ground and put together more stimulus funding, then it is likely that the markets will react very favorably. Having said that, even if a new rescue bill is passed and the market goes up, the fix might still be very temporary.

One of the issues that free money typically comes with is that easy money often shows itself in inflated stock prices. So, the real question is what effect has this easy money over the last 11 years had on the markets?  Are the markets over inflated?  What could the overall, long term effect of this stimulus be?

To answer these questions, we need only look at the Shiller PE ratio. A PE ratio has long been used to assess the value of an equity against the price. The general rule of thumb is that the higher the PE ratio the less value to price the equity has. What the Shiller PE ratio shows is the value to price of the S&P 500, or in essence the financial centric stocks.

Skipping the long and detailed explanations of how the Shiller PE ratio works, what is important to note is that the median of the ratio throughout history is 15.8 and historically, soon after the Shiller PE ration reaches above 30 the markets suffer a 50 percent drop. Over the last several months the Shiller PE ratio has been above 30 and is currently 29.73, measured after the recent 10 percent market drop in the third week of September.

What this means is that when viewed historically, this market is showing clear signs of being inflated. Furthermore, as the market is already showing signs of weakness and fear- any sign that there might be an extended period where the easy money tap could be turned off could be devastating to an already inflated market.

So, to get back to our original question, is the Federal Reserve controlling the market?  It can be concluded that for the moment and likely for the next several months it is likely that the Federal Reserve will be the most important factor in the larger movements of the stock market or at least the role of the Federal Reserve will be. However, as the central bank can only provide new money for stimulus when congress authorizes it, you can decide whether it is Senator McConnell and Speaker Peloci or Mr. Jerome Powell who have the most sway over the current markets.

Aaron Warby is the owner of Online Trading Academy.

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