By Mike Dolan
LONDON (Reuters) – The Federal Reserve will probably keep its distance from the DeepSeek saga during its policy meeting this week, but the U.S. central bank has good reason to keep very close tabs on any artificial intelligence wobble on Wall Street.
One of the curious things about the Nvidia-led plunge in U.S. megacap stocks on Monday, triggered by the emergence of the relatively cheap Chinese generative DeepSeek AI model, was how much the stock shakeout hit U.S. interest rate markets.
As stock benchmarks and tech-led subsets recoiled sharply, so too did U.S. Treasury yields as Fed easing bets increased.
Two-year yields lost up to 10 basis points – dipping below 4.2% for the first time this year – and Fed futures markets moved to fully price in two rate cuts this year, having been hesitant about the second until Monday.
On one level, this may have been just a knee-jerk flight to “safety” at the first hint of a stock market swoon. Or maybe rates traders were just nervy ahead of the Fed’s upcoming policy decision.
What’s almost certain is that the Fed will give the entire incident a bodyswerve when it issues its policy statement on Wednesday. Likely to stand pat on rates this week, the central bank already has its plate full processing the uncertain implications of the proposed policies of President Donald Trump’s new administration.
What’s more, the Fed will not want to appear to be operating a “policy put” for any one company, sector or market.
And yet the sensitivity of the wider U.S. economy to the fortunes of the equity market – and the related wealth effects from a 50% increase in the S&P 500, the most popular U.S. equities index, in just two years – suggests rates markets probably had reason to be jumpy.
‘WEALTH EFFECTS’
Much like the stock market itself, net U.S. household wealth numbers are off the charts – or at least in uncharted territory.
Quarterly Fed data shows the impact of the massive market moves in recent years. Last month’s update shows net household wealth rose by almost $5 trillion in the third quarter of 2024 to a record high of nearly $169 trillion – more than $50 trillion higher than just before the COVID-19 pandemic and almost twice what it was 10 years ago.
Some $3.8 trillion of the increase during the third quarter was down to rising corporate equity values, according to the Fed data. And given that U.S. stocks added another 10% in the final quarter of last year, at least another $4 trillion can probably be added to that total late last year too.
Just how that affects behaviour in the real economy is the question. The “wealth effect” – a belief that rising asset values boost household confidence and consumption – has long been studied and debated.
Even if the scale of the effect is hard to measure – as households’ equity exposure varies from savings accounts to pension pots or even to annual remuneration – one pre-pandemic study suggested that for every $1 rise in stock values, consumer spending rose 28 cents.
So just do the maths. The Fed data shows household equity holdings rose some $12.5 trillion in the year through September last year – and probably about that for the full calendar year. Based on the above rule of thumb, the wealth effect would have boosted spending by about $3 trillion last year – or around 5%.
Obvious caveats to all this include the unequal distribution of equity holdings across the population, with richer households obviously controlling the bulk of the assets. But Fed data also shows almost 60% of U.S. households have some stock exposure, and the 60% of richest households are responsible for almost 80% of total annual expenditures in the economy.
It’s little surprise then that the speed of the stock market rebound after the interest rate squeeze of 2022 was often cited as a major reason retail sales and the wider economy proved so resilient in the face of such a steep rise in borrowing costs.
Indeed, the Chicago Fed’s measure of overall financial conditions in the economy, which includes equity, interest rate and credit metrics, has tumbled relentlessly since the start of 2023 and is now at its loosest reading in more than three years.
And one key reason for the quick market bounceback was the quantum leap in generative AI represented by the launch of ChatGPT in late 2022. The AI frenzy since has catapulted the stocks of a narrow group of chipmaker and AI-related megacaps into the stratosphere, dragging wider indexes with them.
The extent of that narrow leadership is best captured by the fact that the gains in the S&P 500 over the past two years were more than twice that of an equal-weighted index that removes the distortions of the giant leaders.
Even if DeepSeek does not end up being a gamechanger, the market reaction to it still throws a curve ball into the mix and suggests valuations may need to be reevaluated at the very least.
But will a wobble in a narrow section of the equities universe threaten the entire edifice enough to warrant a macro policy reaction from the U.S. central bank? For now, almost certainly no.
But if what was heard on Monday was the sound of a bubble popping, then there are very real economic implications the Fed may need to consider quickly.
The opinions expressed here are those of the author, a columnist for Reuters.
(by Mike Dolan; Editing by Paul Simao)
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