Perhaps the single biggest catalyst for today's ramp (in addition to the biggest short squeeze of 2015) were the following three soundbites from Bill Dudley:
- CASE FOR SEPT RATE HIKE LESS COMPELLING,
- I REALLY HOPE WE CAN RAISE RATES THIS YEAR, and yet
- FED'S DUDLEY SAYS "WE ARE A LONG WAY FROM" ADDITIONAL QUANTITATIVE EASING
... which to everyone was a tacit admission that the door to more QE is already open, and just needs a stronger push.
But the one line that should have been everyone's focus is the following:
- DUDLEY: STOCK DROP HAS LITTLE SHORT TERM EFFECT ON U.S. ECON
The reason why this is interesting, is that Goldman's alumnus at the NY Fed admitted that stock prices - artificial as they may be - are not only a "policy" matter to manipulate consumer psychology and confidence, but have an actual, empirical and quantifiable aspect in to the tightness (or ease) of financial conditions, and thus to the broader economy via all traditional monetary tranmission mechanisms.
In fact, as none other than Dudley's former employer, Goldman Sachs, quantifies it, a 10% market drop has the same impact as a 15 bps rate hike. As a reminder, the Fed has been vacilating for the past year whether or not to hike rates by a paltry 25 bps (just so it can then lower rates by 25 bps and launch QE).
Academic research on stock price effect on policy rates
[11]
In other words, in the past week, ever since the Fed's FOMC minutes which sent the S&P tumbling from 2100 to their lows in the overnight session, some 13% lower, the US economy underwent the functional equivalent of a 15 bps rate hike, or more than half the rate hike that the Fed has been so terrified to engage in for years.
Here is Goldman's explanation:
A review of the economic literature on the monetary policy reaction to stock market changes suggests that a 10% decline in equity prices lowers the fed funds rate by 15bps at the next meeting compared with what it would otherwise be.
[S]tock price changes have a larger effect on expected policy rates, particularly in high-volatility regimes. It is also notable that most of the studies that have examined multiple sample periods find that the Fed's reaction to equity prices was stronger in the pre-Greenspan era and weaker more recently. Studies that exclude the 1987 stock market crash also find a weaker reaction function. Taken together, these lines of research suggest that if the reaction function that prevailed over the last few decades still holds, a 10% decline in stock prices should result in a fed funds rate about 15bps lower after the next meeting than it would otherwise be.
As a rough check, we can also estimate the effect of the stock price decline on the output gap via wealth effects. Scaling household equity and mutual fund holdings as of the end of Q1 by returns since then, a 10% decline in stock prices would reduce household financial assets by approximately $1.9 trillion. In previous research, we have assumed that each dollar change in financial wealth impacts consumption by $0.02, suggesting that a 10% decline in equities should reduce consumption by about 0.2% of GDP. Running this effect through a conventional Taylor rule would suggest that a 10% decline in equity prices, assuming it does not reverse in the near-term, would call for a fed funds rate 10bps to 20bps lower (depending on the coefficient chosen on the output gap) or roughly the same as the effect implied by the median result shown in Exhibit 1.
While one can debate the numbers, the above analysis reveals three things:
- A rate hike is never, ever positive for stocks, because if one does the presented analysis in reverse, all else equal, the tightening of financial conditions by 25 bps would have a comparable and negative impact on stocks (unclear if as big as a 10% correction although certainly possible) as the resulting implied tightening in conditions.
- The market effectively forced more than half a 25 bps interest rate increase in the past week, or about 15 bps to be precise, something which in addition to the much dreaded Fed hike of 25 bps would mean that the Fed is tightening much faster than it wants. In other words the market called the Fed's bluff, and based on Dudley's comment today, the Fed folded.
- If the market really wants to assure that there is no September, or December, rate hike, then it has to tumble by just the amount needed to assure a 25 bps tightening effect is implicitly achieved. Which means drop by 16.666%.
The irony is that by soaring as much as it did, with the Dow recording its third biggest surge in history, the September rate hike is right back in play. In fact, should the S&P rise another 100-150 points, one can be absolutely certain that Yellen will do what he had planned to do before the recent global risk contagion.
Which puts the market in a big quandary: keep buying, and assure the rate hike the will send it plunging, or tumble, avoid a rate hike, and then rise.
The answer, for better or worse, is in the gallium arsenide hands of a few billion HFT momentum-igniting algos.
