The Fed drives market expectations
The Fed is the glue that connects macroeconomic indicators and the market. Because of this, the most important indicators are the ones that influence the Fed’s decision-making process. For example, if earnings in the most recent quarter have been record-setting, but the Fed signals that it wants more contractionary policy going forward, stock prices will fall. If your portfolio isn’t well-positioned for this scenario, you will suffer losses.
The main story driving the stock market over the last four years has been quantitative easing. From QE1 to QE3, markets have rallied while the Fed has been increasing the money supply, and stagnating while it hasn’t. We can likely attribute much of the difference in performance between the US stock market and the European stock market since 2009 to monetary policy. You can also see the power of monetary policy in the performance of Japanese stocks in the last twelve months.
The European Central Bank (the ECB) raised interest rates in 2011, causing a double-dip recession in Europe. The market’s fear of tapering QE is potentially due to investor worry of a similar outcome if the Fed contracts policy too soon. A double-dip in the event of an early taper is a huge risk for US equities, and a good reason for investors to pay attention to potential changes in Fed policy.
The Fed dominates headlines for good reason—and investors shouldn’t ignore it
Investing is all about expectations for the future. Without at least basic knowledge of monetary policy and the Fed’s role in the markets, it’s difficult to be a successful investor. To review, the Fed influences nominal growth expectations, and therefore earnings expectations. It does this by controlling the money supply to influence the inflation rate. Markets anticipate future expected changes in the inflation rate and prices move on new information on the future path of inflation.