The Stock Market and Monetary Policy

Last week's large stock market rally was a vote against the technical arguments for a significant market correction immediately ahead.  Stocks should continue to rally into February.   First, strong US/global economic growth, tax reform, and expectations of solid corporate earnings to be reported over the next several weeks should continue to underpin market gains.  Second, market pundits are well aware of the "rule of thumb" that gains in the first two days of January tend to be associated with a gain for the month, and a gain in January tends to be associated with a gain for the year.  So, any market pullback for the rest of January is likely to be minor, as no one will want to "buck" this "rule."

The biggest threat to the stock market rally is monetary policy.  If the Fed becomes more aggressive than its expectation of three 25 BP hikes this year, stocks will likely correct.  But, this is not yet a high probability.   Indeed, Friday's soft December Payroll increase -- with a steady Unemployment Rate -- argues against such a policy shift.  And, a consensus 0.2% m/m print for next Friday's December Core CPI should not change this argument, as the y/y would be steady at 2.5%.  But, further market gains on top of a strong economy will likely prompt talk of more aggressive Fed policy as we approach the March 20-21 FOMC meeting -- the first meeting when Powell presides as chairman.  So, some market caution may assert itself in late February or March.

The importance of monetary policy for the stock market is seen in 1987, the year after the previous tax reform legislation.  A massive stock market rally in the first 3 months of the year was stopped by a 75 BP hike in the funds rate over April and May.   The market rally resumed when the Fed pulled back from tightening in early July, but was cut short by large hikes in the funds rate in August and September.  Note that even with the October crash, the Dow Jones Industrial Average ended the year above its year-end level in 1986 -- consistent with the January rule of thumb.


                              Monetary Policy and Stock Market in 1987
                     Fed Funds Rate Target                               DJIA
                       (level, percent)                  (month-end to month-end % change)
Jan 1                   5.875                              Jan                 13.8
Jan 5                   6.00                                Feb                  3.1
April 30                6.50                               Mar                  3.6
May 22                6.75                                Apr                 -0.8
July 2                  6.25                                May                  0.2
Aug 27                6.75                                Jun                    5.5
Sep 4                  7.25                                Jul                     6.3
Sep 24                7.3125                           Aug                    3.5     -- peak Aug 17
                                                                 Sep                    -2.5
                                                                 Oct                   -23.2