The Fed Just Gave the Stock Market a Green Light for 2021

The stock market finished Wednesday on a mixed note, as we've seen increasingly over the past couple of weeks. Talk of economic stimulus is starting to get louder, and that helped bolster broader indexes like the S&P 500 (^GSPC 0.02%) and Nasdaq Composite (^IXIC 0.10%). Meanwhile, the Dow Jones Industrial Average (^DJI -0.11%)lagged, pulled down largely by weakness in Boeing (BA -2.87%) and Honeywell (HON -0.70%).

Data source: Yahoo! Finance.

Many market participants had looked forward to what the Federal Reserve would say at the end of the last monetary policy meeting of the year. Yet when the announcement came, the reaction in the market was muted at best, providing only the smallest of boosts for markets. That's surprising, because what the Fed said essentially gives stock market bulls the go-ahead to keep expecting extremely favorable conditions well into 2021 and perhaps even beyond.

What the Fed said

The Federal Reserve restated its commitment to provide support for the U.S. economy. In doing so, it intends to keep using its full range of available tools in order to promote maximum employment and maintain price stability.

Image source: Getty Images.

The Fed remains focused on the COVID-19 pandemic and its economic impacts. Although policymakers are pleased to see some gains in employment and levels of economic activity, they're still troubled that a full recovery is still a long way ahead. Because weakness in the economy is keeping prices low, inflation isn't nearly as much of a concern as it normally would be. That gives the Fed greater latitude to keep interest rates low for a considerable period into the future.

Specifically, the Fed is likely to keep its short-term interest rates in their current range of 0% to 0.25% indefinitely, pointing to the time at which labor markets return to maximum employment conditions and inflation rises to slightly above 2%. The central bank will also make longer-term bond and agency-backed securities purchases totaling at least $120 billion per month, keeping longer-term rates lower as well and keeping the yield curve flat.

How the Fed is feeding the stock market

The Fed's actions have essentially made mainstream alternatives to stocks impractical for most investors. Those who want to keep cash available can expect little or no interest at all, and with inflation still positive, that means savers are losing purchasing power every month on their cash savings. Even those willing to lock up money in bonds or CDs for five to 10 years can't expect to get much more than 1%, which again isn't enough to keep up with rising prices even at their currently subdued levels.

Low rates are also bolstering the case for other high-risk assets. For instance, commodities like gold benefit from low borrowing rates, as it's easier for traders to take positions that would benefit from rising gold prices.

However, not all stocks are set to benefit from the Fed's actions. Bank stocks are prone to struggle in the Fed's flat yield curve environment, because they no longer have a wide spread between the interest they collect from lenders on longer-term loans and the interest they pay depositors on their bank accounts. Low rates have crimped bank profits for quite a while, and it's likely to continue indefinitely.

Watch the Fed in 2021

Although the Fed will be slow to act, many will look at every word in its statements next year in search of subtle changes that could signal a shift in policy. For now, though, stock market investors have the green light to expect a friendly Fed for the foreseeable future, while those hoping for better rates on cash and bonds will have to wait a long time.