There’s an old expression on Wall Street: “Don’t fight the Fed.” It means that investors should invest in a manner that aligns with the current monetary policies of the Federal Reserve, rather than against them. Let’s explore this idea further.

For good reason, many stock market participants closely monitor the Federal Reserve’s every move. As the U.S. central bank, the Fed has control over short-term interest rates and money supply.

When the Fed wants to stimulate the economy, it is said to be “dovish.” It can lower short-term interest rates and increase the money supply.

When the Fed wants to fight inflation and prevent over-heating, it is said to be “hawkish.” In this case, it can raise short-term interest rates and decrease the money supply.

How the Fed’s Policy Helps

A dovish Fed helps the stock market primarily in two ways.

Firstly, low interest rates can boost the economy and stocks usually do well when the economy is good. Secondly, when interest rates are low, stocks’ potential return looks more attractive.

For example, stocks are considered to be riskier than fixed income instruments, like bonds. If bonds offer a high yield, investors would more likely buy bonds than risk their money in stocks. But when bonds yield very little as they do now, investors would more likely buy stocks because they offer the potential for a higher return.

This is why when Fed officials were implying at the end of last year that they would keep raising interest rates even though there were signs of an economic slowdown, it sent the stock market into a tailspin. Early this year, they changed their minds, and stocks immediately started to rise again.

Interest Rates and Income Stocks

Interest rates particularly affect income stocks. Investors buy these types of stocks for dividend income. When people think interest rates will go higher, there’s less demand for income stocks. This is why when inflation and interest rate expectations were rising in early 2018, income stocks took it on the chin. When those expectations fell, income stocks rallied.

In the third quarter the Fed cut interest rates twice, and economic worries lingered. It comes as no surprise that best performing S&P 500 sectors in the third quarter were utilities and real estate. Both sectors are known for being conservative and dividend-rich investments.

The Latest Fed Move

You’ve probably heard on the news about the Fed rate cuts, but the Fed has also started buying Treasury securities this month. It will keep buying Treasury bills (maturity of one year or less) until at least the second quarter next year. The initiate purchase target is $60 billion per month.

Technically, the Fed is doing this to respond to a brief liquidity squeeze in the banking system. The Treasury bill purchases will help to increase reserves banks have on hand. However, it’s also had the secondary effect of pushing down short-term yields.

Since May, the Treasury yield curve has been inverted, which means short-term Treasury yields are higher than long-term Treasury yields. The inversion happens when people are so worried about the near term that they lock their money into long-term Treasury debt for safety. (When demand for Treasuries goes up, Treasury yields go down.)

Many stock investors have been worried because historically an inverted Treasury yield curve has been a good recession predictor. However, inverted yield curves themselves don’t cause recession.

In the past, they tended to predict liquidity problems caused by Fed tightening monetary policy, which can hurt the economy. But as we’ve discussed, the Fed is now easing. Its latest move to buy Treasury bills has helped to close the gap between the 1-month and 10-year Treasury yields.

To be fair, the gap has also closed because in recent days, hopes for a resolution of the trade war between the U.S. and China have risen, but there’s no denying that the Fed has helped.

Stock Dividends Even More Attractive

Previously, the inverted yield curve gave investors a chance to earn a higher return without locking up cash for a long time by buying short-term fixed income instruments. Now, even short-term yields are dropping.

We have long favored stocks for income compared to fixed income because stock dividends offer the potential for growth. The latest development in Treasury yields makes quality companies with steady revenues, cash flow, and growing dividend even better.

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