How The Fed May Kill The 2018 Stock Rally

Many investors have argued the great bull stock market eventually will be brought to its knees by a myriad of pressures such as high valuations, a conflict with North Korea, a spike in oil prices or other events. But the biggest threat to U.S. equity markets in 2018 may be much closer to home in the Federal Reserve, whose actions wield enormous power over the economy, CNBC reports.

"The biggest risk to the rally is the FOMC," said Kristina Hooper, global market strategist at Invesco Ltd., referring to the Fed committee that makes interest rate decisions. Because of major changes on the FOMC, "Some of the most dovish voting members have rolled off, so this could be a different environment, especially if they see signs of inflation," she told CNBC. That could make the Fed more hawkish, or more prone to increase interest rates.

Right now, there is a mismatch of expectations that could jolt the stock market. Investors recently have expected only two Fed rate hikes this year while the Fed has indicated it will raise rates three times. Also, the Fed may decide to tighten the economy much faster than investors expect if GDP growth continues at 3 percent. The Fed's motive would be to prevent the economy from overheating and firing up inflation.

An extreme example of the Fed's impact occurred in 1981, when it raised short-term interest rates near 20% in order to combat inflation that was galloping at about 14%. While the rate hike was critical in reining in inflation, it also spurred a severe recession lasting through 1981 and 1982 that was the worst in U.S. history between the Great Depression of the 1930s and the recession of 2007-09, per Federal Reserve History. (For more, see also: How Interest Rates Affect The U.S. Markets.)

By contrast, since the 2007-09 recession low interest rates have been key to the economy's expansion. In response to the financial crisis of 2008, the Fed slashed the fed funds rate and held it near zero through 2015, per the Federal Reserve Bank of St. Louis. This was a key factor in stimulating the economy, and spurring the great bull market that began in March 2009, which has seen the S&P 500 Index (SPX) rise more than 300%.

As indicated, a major changing of the guard in 2018 in key positions may reshape Fed policy. The chair of the Federal Reserve Board of Governors also chairs the FOMC, while the president of the Federal Reserve Bank of New York serves as its vice-chair. Janet Yellen will be replaced as chair of both the Board of Governors and the FOMC by Jerome Powell in February. William Dudley of the New York Fed has announced his intention to retire by mid-2018, and a search for a successor is underway. Powell holds similarly dovish views to Yellen, according to Reuters.

Marvin Goodfriend, a professor of economics at Carnegie Mellon University, has been nominated to take an open seat on the Fed Board. While critical of the Fed's direction under Yellen, and known as an anti-inflation hawk, he also believes that the Fed should take action against deflation as well, Bloomberg reports. Goodfriend favors formula-based policies for setting interest rates, such as the Taylor Rule, Bloomberg adds.

There are two other open seats on the Fed Board, and a third will open up when Yellen retires in February and Powell moves up from board member to chair. All nominations to the Fed Board by President Trump are subject to confirmation by the U.S. Senate. Quincy Krosby, chief market strategist at Prudential Financial, says, "If you look at the background of the new Fed board members, you would have to put them on the bit more hawkish side of the equation," per another CNBC story. However, he added, "How much more hawkish, we don't know."

If GDP continues to show sustained growth above 3%, and if that sparks inflation above the Fed's 2% target rate, expect the Fed to "go from tapping the brakes to slamming them," CNBC says. At its December policy meeting, the Fed voted 7-2 in favor of raising interest rates, per the Wall Street Journal. They saw inflation pressures building in a strong labor market, as well as from the stimulative effects of the recently-enacted federal tax cuts.