Remember, this index is designed to incorporate the lags of monetary policy, and project (in this case) one-year forward what the impact will be on real GDP growth.
If the line is above zero, financial conditions are expected to be a drag on growth (restrictive policy). If it’s below zero, financial conditions are expected to be a boost to growth (stimulative policy).
Also remember, each of the periods in the chart that shared the characteristic of “historically tight levels” (i.e. the peaks on the chart) were soon followed with some form of Fed easing (either rate cuts, QE, or in the case of 2015-2016 – walking back on projected rate hikes).
As you can see to the far right of the chart, one of those peaks was last October.
And as we know, that’s when Jerome Powell signaled the end of the tightening cycle, and the Fed started telegraphing the easing cycle.
With that, back in that December 4th note (here), we also discussed the performance of stocks following each of the turning points in the chart (the peaks). Stocks did very well in the subsequent 12-month period — and small caps outperformed.
Let’s revisit that analysis and take an updated look at small cap performance since that October peak/turning point in the chart above.
So, the Russell 2000 (small cap stocks) is now up 39% since the Fed’s pivot to a dovish stance on rates back in October — running right around the average return for small caps after these turning points.
And we’ve had about 10 percentage points of that performance just since the CPI report last Thursday.
But as you can see in this longer term chart for small caps, we remain about 8% away from the all-time highs. And the tailwinds are just forming.
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