Stocks, The Virus, And The Fed

One thing is clear; stocks are reacting to both the virus and the Fed. Indeed, right now almost nothing else seems to matter. How can we understand this pattern?

The current value of the stock market is quite closely correlated with the expected value three years in the future. And the expected value of stocks three years in the future depends heavily on where investors currently believe NGDP will be three years in the future. That is, current monetary policy expectations are heavily influencing future expected stock values, which influence current stock values.

At the same time, the virus is obviously the primary force impacting the market in recent weeks, while monetary policy is a secondary factor. So how does that mesh with the previous claim that Fed policy is driving the market? The answer is provided in the Fed funds futures market, where rates have fallen to barely over 0.6% in early 2023. The market is afraid that the virus won’t just depress aggregate supply during this year; it will also (indirectly) depress aggregate demand for a number of years.In other words, the market fears that the virus will cause the Fed to tighten policy, that is, raise the policy interest rate relative to the equilibrium interest rate.

Today’s mild bounce-back was driven by expectations of central bank stimulus:

The S&P 500 jumped more than 3%, the most in a year, after news that Group of Seven finance ministers and central bankers will hold a teleconference Tuesday to discuss how to respond to the outbreak.

The hope is that this will prop up demand after the worst of the crisis is over:

“Markets are already looking beyond the first half, looking toward the second half to see whether or not we get a recovery in demand,” said Anik Sen, global head of equities at PineBridge Investments, which has about $101 billion in assets under management.

Tyler Cowen has another hypothesis:

So one way to think about Covid-19 is as a test of various systems around the world — political, medical and economic. Markets believe those systems are failing that test.

I suspect this is also a part of the story, but not the primary factor.

Over at Econlog I discuss how the coronavirus might impact the business cycle, and argue that the Fed probably could not and should not try to prevent a fall in NGDP growth this spring.