Stock market tumbles: How the Fed caused a freakout

When it comes to the stock market, the Federal Reserve can’t win.

Many people had warned that the Fed shouldn’t raise interest rates on Thursday because it would destabilize an already weak market. And the Fed didn’t. It kept rates at zero. But that wasn’t enough to keep investors calm. On Friday, the Dow Jones Industrial Average dropped 289 points.

What’s got the market freaked out? First of all, the Fed’s statement. It wasn’t all that surprising that the Fed didn’t raise interest rates. Many people suspected it wouldn’t. What was surprising was that the Fed was more cautious in its statement explaining why it wasn’t raising rates than many people predicted it would. In particular, the Fed said that worrisome conditions in the global economy could slow things down at home. A lot of people thought that was code for a warning about China. The Fed also said inflation is not likely to materialize for a while. One Fed governor even thought interest rates should drop from here, into negative territory.

In Fed speak, investors were expecting a “hawkish hold,” meaning the Fed wouldn’t raise rates, but would say that economy was strong enough to do so. Instead, the central bank delivered what some people are calling a “dovish hold,” meaning they didn’t raise rates yet at the same time signaled there is reason to believe they wouldn’t raise rates next month either. In fact, investors, as measured by the Fed funds futures market, are now saying there is only an 18% chance the Fed will raise interest rates in October, and 44% and predicting a hike the month after that.

That, of course, should be good news for the market. Lower interest rates are normally positive for stocks, and it’s what many people say has been fueling the bull market all along. But there had been warning signs that the economy was not as strong as it initially seemed. Just the same, there had been growing confidence that the U.S. economy was on strong footing and that not even China or a Fed interest rate hike could stop that upward trajectory. In essence, the Fed’s recent statements cast considerable doubt over that line of thinking.

Instead, the central bank gave some credence to the idea that the current economic expansion may be closer to the end of its run, rather than in the middle. And that got the market worried. “I think a few people were out over their skis on how strong the economy was,” says Jeff Korzenik, chief investment strategist for Fifth Third Bank. “The Fed may have given them a more realistic view of where the economy really is.”

The market didn’t fall at that much on Friday, or even at all, depending on how you look at it. Stocks rose a little over 100 points on Tuesday, and 200 points on Wednesday. They were up another 100 points before the Fed’s decision. And on Friday, the market dropped nearly 300 point. Put it all together and meh. The Fed did nothing, and the market did nothing. For the whole week, stocks were a little bit down, but not by much.

There’s another way to view this situation, which is a little more concerning, at least for investors. The Fed seemed on track to raise interest rates and then the stock market dropped. Yellen has said the Fed still wants to raise rates but it has held off because of concerns about the global economy. But the global economy, namely China, isn’t likely to improve quickly. The stock market, on the other hand, could bounce back quickly. So, what Yellen and the rest of the Fed are saying is that when the market improves, a rate hike will follow. “They seem to be signaling that if the market rallies too much, we are going to put a cap on it,” says market strategist James Bianco, who heads up his own firm Bianco Research.

But Bianco admits, along with several others, it’s a lot harder than normal to determine what has investors worried right now. “Stock market, China, economy, it could be any of those things or a mixture that got to the Fed,” he says.

One thing is certain: with stocks already trading at very high valuations, it doesn’t take a lot to freak investors out.

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