December 2018: The Selloff That Ended With the Fed Reversing Course

By Christmas Eve of 2018, the S&P 500 had fallen more than 19 percent from its September high, brushing against the informal 20 percent threshold commonly used to mark a bear market, in what had been, up to that point, one of the worst Decembers for US stocks since the Great Depression. Eleven days later, stocks surged as Powell signaled greater patience on further hikes and a strong jobs report eased immediate recession fears on the same morning. The episode is a compact illustration of how a large shift in expected central-bank reaction can move markets sharply in both directions within a matter of weeks, even when the underlying economy hasn't moved by anything close to the same magnitude.

The backdrop: a Fed on a preset course. The Federal Reserve had been raising rates through 2018 as part of a gradual normalization from the near-zero levels held since the 2008 financial crisis, and had also been steadily shrinking its balance sheet by letting bonds mature without reinvesting the proceeds. Powell himself described that balance-sheet runoff as being on "automatic pilot," with interest-rate policy left as the active tool for responding to incoming data. By December, markets were increasingly worried about slowing global growth, trade tensions, and the risk that the Fed would keep tightening into that slowdown rather than adjusting to it.

December 19: the Fed hikes anyway. The Fed raised its benchmark rate for the fourth time in 2018 and, in the press conference that followed, Chair Jerome Powell signaled the balance-sheet runoff would continue at its existing pace, language markets read as unwilling to slow down despite the mounting concerns. Stocks fell sharply in the days that followed.

December 24: Christmas Eve, and a near bear market. The Dow fell 653 points, its worst Christmas Eve session on record, a decline of roughly 2.9 percent, while the S&P 500 fell 2.7 percent and closed roughly 19 to 20 percent below its September high, at the edge of what's conventionally called bear-market territory. The Nasdaq was down about 22 percent from its own August peak. Trading volume was thin, a holiday-week market with few buyers willing to step in, which tends to make moves in either direction larger than they would be on a normal trading day.

January 4, 2019: the pivot. Speaking on a panel at the American Economic Association's annual meeting, Powell said the Fed could be "patient" as it assessed the economy going forward, language that echoed a term his predecessor Janet Yellen had used in a similar context, and markets read it as a specific, recognizable signal that further hikes weren't a foregone conclusion. The remarks landed the same morning as a stronger-than-expected December jobs report, so the day's rally reflected both pieces of news together rather than the Powell comments in isolation. The Dow rose roughly 750 points that day, a gain of about 3.3 percent, one of its largest single-day point gains on record at the time.

What changed between December 19 and January 4. No comparable two-week transformation had occurred in the underlying economy, growth, employment, and inflation data all moved far more gradually than that. What changed much more sharply was the market's read on the Fed's reaction function. A Fed perceived as mechanically committed to a preset tightening path, regardless of financial-market stress or growth concerns, was read as a real risk to the economic outlook. A Fed perceived as willing to adjust that path in response to incoming conditions removed a specific source of that risk, even before any actual policy change had been made, the January 30, 2019 meeting statement and subsequent months would go on to confirm the shift with actual pauses and eventually rate cuts later in 2019. Markets price a central bank's reaction function, not just its most recent decision, and a shift in how automatic or responsive that function is perceived to be can move prices sharply even before a single policy rate actually changes.