Why Market Stability Matters to the Fed

0:00Mike Wilson:Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley, CIO and Chief U.S. Equity Strategist. Today in the podcast, I'll be discussing the Fed's decision last week and what it means for stocks. It's Monday, December 15th at 1130 a.m. in New York. So let's get after it. Last week's Fed meeting provided incremental support for our positive 2026 outlook on equities. The Fed delivered on its expected hawkish rate cut, but also indicated it would do more if the labor market continues to soften. More important than the rate cut was the Fed's decision to restart asset purchases. More specifically, the Fed intends to immediately begin buying$40 billion of T-bills per month to ensure the smooth operation of financial markets.

0:47Mike Wilson:Based on our conversations with investors prior to the announcement, this amount and timing of bill buying exceeded both consensus and my own expectations. It also confirms a key insight I've been discussing for months and highlighted in our year-ahead outlook. First, the Fed is not independent of markets, and market stability often plays a dominant role in Fed policy beyond the stated dual mandate of full employment and price stability. Second, given the size of the debt and deficit, the Fed has an additional responsibility to assist Treasury in funding the government, and will likely continue to work more closely with Treasury in this regard.

1:26Mike Wilson:Finally, the decision to intervene in funding markets sooner and more aggressively than expected may not be quantitative easing as defined by the Fed. However, it is a form of debt monetization that directly helps to reduce the crowding out from the still-growing Treasury issuance, especially as Treasury issues more bills over bonds. At the Fed's October meeting, it indicated some concern about tightening liquidity, which I've discussed on this podcast as the single biggest risk to the bull market in stocks. Evidence of this tightness can be seen in the performance of asset prices most sensitive to liquidity, including cryptocurrencies and profitless growth stocks.

2:05Mike Wilson:While the Fed probably isn't too concerned about the performance of these asset classes, it does care about financial stability in the bond, credit, and funding markets. This is what likely prompted it to restart asset purchases sooner and in a more significant way than most expected. We view this as a form of debt monetization, as I mentioned, given the Treasury's objective to issue more bills going forward. More importantly, these purchases provide additional liquidity for markets, and in combination with rate cuts, suggest the Fed is likely less worried about missing its inflation target. This is very much in line with our run-it-hot thesis dating back to early 2021.

2:45Mike Wilson:As a reminder, accelerating inflation is positive for asset prices as long as it doesn't force the Fed's hand to take the punch bowl away like in 2022. Ironically, the risk in the near term is that this larger-than-expected asset purchase program may be insufficient if the Fed has materially underestimated the level of reserves necessary for markets to operate smoothly. This is what happened in 2019 and why the Fed created the standing repo facility in the first place. However, this is more of a tool that is used on an as-needed basis. What the markets may want or need is a larger buffer if the Fed has underestimated the level of reserves required for smoothly functioning financial markets.

3:28Mike Wilson:To be clear, I don't know what that level is, but I do believe markets will tell us if the Fed has done enough with this latest provision. Liquidity-sensitive asset classes in areas of the equity market will be important to watch in this regard, particularly given how weak they traded last Friday and this morning. Bottom line, the Fed has reacted to the market's tremors over the past few months. Should markets wobble again, we're highly confident the Fed will once again react until things calm down. Last week's FOMC meeting only increases our conviction in that case and keeps us bullish over the next 6 to 12 months and our 7 ,800 price target on the S &P 500.

4:06Mike Wilson:We would welcome a correction in the short term as a buying opportunity. Thanks for tuning in. I hope you found it informative and useful. Let us know what you think by leaving us a review. And if you find thoughts on the market worthwhile, tell a friend or colleague to try it out. The preceding content is informational only and based on information available when created. It is not an offer or solicitation, nor is it tax or legal advice. It does not consider your financial circumstances and objectives and may not be suitable for you.