Fed stopped? Markets are hoping, but it probably won’t happen yet

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Will the Fed stop raising interest rates when the markets are right? This is the question everyone is trying to answer. Of course, after more than a decade of monetary interventions, investors have developed a “Pavlovian“ Response to market declines and Federal Reserve status.

classical conditioning (also known as Pavlovian or Conditioning the respondent) refers to an educational procedure in which a strong stimulus (such as food) is paired with a previously neutral stimulus (such as a bell). What Pavlov discovered was that when a neutral stimulus was introduced, dogs would begin to salivate in anticipation of the strong stimulus, although it is not currently present. This learning process results from psychological “coupling” of stimuli.

Importantly, for conditioning to work, the ‘neutral stimulus’ when presented must follow the ‘strong stimulus’, until the ‘coupling’ is complete. For investors, with the introduction of each round of “quantitative easing,” “neutral stimulus,” the stock market rallied, and “strong stimulus.”

Every time there was a more fundamental correction in the market, central banks acted to provide “Natural stimulants.”

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So, with the market entering one of its toughest starts ever into a new year, investors are asking the following question:

“What does this mean for the economy and how much damage the Fed would have to do to stop? “

The Fed still sees a bull market

Investors have come under a tremendous amount of pressure this year. As Ethan Harris recently pointed out in a note from BofA:

“People close to the market are understandably unhappy with the decline in the S&P 500 since the end of last year.“

The chart below is ‘Investor View of the S&P 500 Index.

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In other words, as I discussed in February, everyone is wondering where “Fed Status”he is. lightness:

“Fed Status” is the level at which the Federal Reserve is Will take action to support Asset markets by reversing price increases and restarting quantitative easing programs.

In February, a survey of Bank of America fund managers tied 3750 to the level they believed to be “Fed Status” Live.

However, by April and May, BofA’s review of the file “Fed Status” Levels drop to 3500.

Exit targets are slightly different because they are indicative of the Fibonacci retracement levels from the March 2020 lows. From the highs of the market close, the targets are:

• 38.2% price increase = 3829 = 20% market decline (The Fed will probably be concerned)
• 50% price increase = 3523 = 27% market decline (Margin calls triggered. Fed probably will.)
• 61.8% price increase = 3217 = 33% decline in the market (Fed mode is on)

Interestingly enough, the 33% decline only erases market gains from early 2020.

There are two reasons why “Fed Status” It may be less than 3500.

The first reason is that the Fed sees things differently than Wall Street or individual investors. While the market has fallen this year, the market is still higher than it was in 2020. The Fed does not mind “inflation” In asset prices to reduce the excess speculation in the market. Moreover, the market slump also contributes to the tightening of monetary policy to ease inflationary pressures.

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While stock prices are important, it is the credit market that the Fed is focusing on.

No credit stress means the Fed won’t stop

When it comes to the financial markets, the primary focus of the Federal Reserve is to Financial stability.After the financial crisis, the stability of credit markets became the primary focus of the Federal Reserve. As previously noted:

“As the financial ecosystem is now more leveraged than ever, “Instability instability” It is now the most important danger. The “The stability/instability paradox” It assumes that all players are rational and that rationality means avoiding total destruction. In other words, all players will act rationally, and no one will press the “big red button”.

As retail investors wonder when the Federal Reserve will intervene, there is little evidence of severe market pressures. At the moment, credit spreads are not rising significantly, which indicates that the bond market is operating normally. With inflation soaring, the spread between junk and A-rated bonds gives the Federal Reserve room to raise interest rates for the time being.

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While credit spreads rose and markets declined, this remained orderly, as evidenced by the weak rise in volatility. However, the Fed is sensitive to credit markets and previously acted quickly at the first sign of turmoil.

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No disorganized breakdown. The Fed will remain focused on equities staying above their pre-crisis peak. As BofA notes:

“Since in a typical consumption model, households respond to persistent price changes over three years or so, the Fed is convinced that the wealth effect remains positive.”

From this perspective, and with a bit of pressure in the credit market, the Fed can remain focused on fighting inflation.

Make no mistake, however, as the Federal Reserve continues to raise interest rates, there is an increased risk of that “Organizer” Markets become fast “unorganized.“

The Fed will “pause” Rising prices?

This is the answer “yes.”

The only questions are “when will it happen”, And the “How quickly will the Fed have to reverse course?”

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Editor’s note: The bulleted summary of this article was selected by searching for the alpha editors.