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How is the Federal Interest Rate hike going to affect the Stock Market?
A primer on Fed rates and a historical analysis on how changes in Fed rate affect the stock market
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The U.S Federal Reserve has finally given a clear indication that it intends to increase the interest rate to combat inflation in 2022.
With inflation well above 2% and a strong labor market, the Committee expects it will soon be appropriate to raise the target range for the federal funds rate - Federal Reserve Statement
I would say the committee is of a mind to raise the federal funds rate at the March meeting, assuming that conditions are appropriate for doing so - Jerome Powell
The borrowing rates had been left unchanged at near-zero since the start of the pandemic. While this has undoubtedly helped the stock market, it has also caused inflation to keep rising unabatedly through the last year.
With an almost guaranteed rate-hike coming this March, let’s dive deep into what the U.S Federal rate is, how it’s used to control inflation, and finally, how the historical changes in the rate have affected the stock market.
While the conventional wisdom is that rate hikes, in general, are not good for stock market returns, the data seems to tell a totally different story!
What is the Federal Rate and how does it work?
The fed funds rate is the interest rate banks charge each other to lend Federal Reserve funds overnight. To put it simply, it showcases how expensive it is to borrow funds. The Fed rate influences how much you end up paying as interest on your mortgage, consumer loans, and credit cards1.
The Fed uses the interest rates as a control pedal to grow the economy or put brakes on it if it gets super-heated. As you can see from the below chart, whenever the economy was growing rapidly (2004-2007, 2017-2019), the interest rates would be increased so that inflation would be under control. But when the economy undergoes a recession period (like just after the 2008 crisis or in the case of the 2020 Covid Pandemic), the Fed lowers the interest rate so that it becomes cheaper to borrow funds.
The idea here is simple. If the borrowing costs become very cheap (as they are now), it becomes very easy for businesses and consumers to borrow money → either for business expansion or personal needs, thereby pushing more money into the economy and getting it out of recession. This is why the rate was virtually zero from 2008 to 2015 and from Mar’20 to now.
The reverse is also true. If the economy grows too fast and inflation gets out of control (again, as it is now), Fed can increase the borrowing rates so that it becomes more expensive to borrow funds. This would reduce the amount of borrowing and the money being pumped into the economy, causing it to cool down and reduce inflation.
How do changing rates affect the stock market?
When the fed increase the rates, it influences the stock market in multiple ways.
Since it’s now more expensive to borrow money for individual consumers as they are impacted through increasing credit card rates and mortgage interest rates (if it’s variable), the amount of money consumers can spend decreases. When we have less discretionary income, overall business revenue and profits decrease as consumers stop buying products.
On the business side of things, the increasing interest rates would cause slowing down of expansion strategies as borrowing for growth is now expensive. Add to this the flagging consumer demand, and it’s a recipe for low earnings reports which would inevitably drive the stock price down.
Rising interest rates make bonds much more attractive. Take an extreme example of the 1980s’ inflationary period where the Fed rate went as high as 20%! This means that you could have had a risk-free return of 20% on your invested money. Very very few people then would invest in the stock market leading to declining stock prices.
Finally, if you have been an astute observer, you would have noticed that growth stocks take the biggest hit when the interest rates rise. This is mainly because of how the company valuation is calculated. A lot of investors use Discounted Cash Flow (DCF) to assign a fair value to the company. In the case of growth stocks, most of the expected cash flow would occur in the future. Given that the current interest rates are rising, the present value of expected future cash flow reduces, making the company less valuable in general!
How has the stock market reacted to previous Fed rate changes?
Even though we now know that rate increases are bad for the stock market, let’s see how the returns have compared across different periods of rate changes.
Surprisingly, on average, SPY has given 9% CAGR during the period of rate increases whereas it has returned -3% during the period of rate decreases.
This can mainly be attributed to the rate decreases occurring during extremely turbulent times in the market (just after the 2000 dot-com bubble, 2007 financial crisis, 2020 covid, etc). Contrary to this, rate increases generally occur when the economy is becoming overheated. Even though this does put a dampener on the stock returns, as we can see from the below chart, it gives respectable returns. What’s even more interesting is that, not even in one period of rate increase did we have negative returns!
As expected, the maximum returns were generated when the Fed Rates were steady and low. SPY returned a CAGR of 15% from Jan’09 to Nov’15 and a whopping 39% from May’20 to Jan’22 when the rates were held steady near 0%.
With the Fed giving a clear indication of the upcoming rate hike, it does seem like the best returns from the market are behind us. But, this does not mean that we should change our equity allocation significantly as we still get decent returns during periods of rate hikes.
Adding to this, only in one short rate hike (Jan’99 to Dec’00) did the Fed rates perform marginally better than SPY. In every other period, SPY did significantly better. Even if the Fed increases the rate by 4 times as expected by Goldman Sachs, as per historical trends, the equity market is bound to give better returns.
Until next week…
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This is because the Fed reserve rate is the lowest rate at which a bank can legally lend.
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