By Philip Moskie
The stock market’s first reaction is usually to sell off when the fed raises the fed funds rate. Many times, stocks will trade back up and even go higher if the rate hike is perceived as a positive move for business and the economy and if it is in line with the expectations of the market. If the rate increases are perceived to be too restrictive on the money supply or if the size and timing of the hikes are not aligned with the expectations of the market, then stocks will trade lower.
Table of Contents
- Introduction
- Case Study 2018-2019
- What action did the fed take?
- Why did the market go up?
- What did we learn?
- Why does the market usually sell off?
- Conclusion
Introduction
The purpose of this article is to explore the premise that the stock market sells off every time the fed raises interest rates. We will use 2018 as a case study since this was the last time the fed actually raised rates. The results surprised us, and we think they will surprise you.
We then review the actual reasons the market sells off when it does. This will allow you to be aware of the reasons why the sell offs occur so you can be on the lookout for the warning signs while you are trading.
Case Study 2018-2019
To fully understand the effect of rate hikes and how the stock market may react we need only look to the last time the fed raised rates. We are going to take a look at 2018 and 2019. The fed also raised in 2017 and 2016 but let’s concentrate on rate hikes of 2018 and the subsequent rate reductions of 2019.
Key terms:
The Fed: the fed is the 7-member board that runs the federal reserve bank, the central banking system of our country.
Basis Points: is one hundredth of one percent. Therefore, if the fed raises rates 25 basis points that is the equivalent of a quarter of a percent or .25
Fed Funds Rate: the fed funds rate is the interest at which the fed lends money to commercial banks to conduct their business.
What action did the fed take in 2018?
In 2018 stocks were in the middle of a strong bull market cycle. The economy was exploding from recent tax cuts and reduced regulation and started to heat up too much. An interest rate hike or two was seen as a welcome move by the market and it continued to rise when the fed started raising rates. However, the market ran into trouble when the fed overreacted and raised rates 4 times that year.
Dow Jones Industrials 2018: (Chart is from Tradingview.com)
As you can see, the fed raised rates .25 basis points in both March and June. This brought the fed funds rate from 1.5% to 2.00% and the Dow Industrials rallied going from $22,357 to $26,763 for an increase of $4,406 or 20%.
Why did the market go up?
The stock market can certainly rally in response to an interest rate hike if that hike is seen as something that is really needed to help our economy and therefore the markets. It also needs to stay in line with expectations of the market. In this case of 2018 the first two hikes certainly met this criteria.
Then what happened?
In September and December, they went too far. They increased the rate again two more times (.25 basis points each bringing the fed funds rate to 2.5%) and the market sold off to $22,377 from $26,763 or a drop of 16%. We believe that the fed knew they went too far with the rate hikes when they included wording in the last announcement that basically said, “we promise not to raise rates anymore”. This to me was an acknowledgement that they knew their actions were not in line with the market’s expectation.
It’s important to note that the fed had to reduce rates 3 times in 2019 because their hikes in 2018 slowed the economy too much. The market knew this and that is why it sold off after the third hike.
What did we learn?
When interest rate hikes are perceived as being necessary, they can be good for the market and the economy. When the fed gets too aggressive in raising interest rates it can have the opposite reaction. It is a real balancing act and sometimes more of an art than a science.
The stock market is a place where perceptions are very important. If the perception is that the number of rate increases or the size of those increases is too excessive the market will perceive it to be detrimental and sell off. Sometimes perception is that the fed moves are not strong enough and once again this can result in a sell off because investors feel that the fed is moving too slowly to correct the situation.
But why does market usually sell off?
Interest rate hikes result in the market selling off usually for one or more of the following reasons:
Interest rate hikes reduce future earnings.
Rising rates means that a company must pay more for the financing they use to run the business. That additional cost takes money right out of the bottom line of the company. This means that if a company is earning $1 per share now, with increased interest rates the future value of that dollar in earning might be reduced to $.95 or $.90 in the future. This may result in a company missing its earnings expectations and the stock dropping. When the fed raises interest rates, the market anticipates this as a whole and the market may sell off to compensate for this action.
Higher rates on less risky assets draws money away from stocks
Interest rates on fixed income investments over the last 10 years have been extremely low due to the low fed funds rate. They have been so low that most investors had to take on the risk of the stock market to try to get a reasonable return on their money. As the fed funds rate increases and bonds and other fixed income investments start to show a reasonable yield, they tend to draw some of that money back from the stock market.
Higher interest rates leads to reduced consumer demand
When rates go up, consumer demand goes down. When we say consumer, we mean individuals and also companies (if you sell B2B). As prices go up and profit levels shrink, most companies start to look at cost cutting or austerity measures to control the drop-in profitability. When the fed raises interest rates companies must be aware of how it will affect not only themselves but also their customers.
Market Expectations
The stock market will have expectation of how many times rates will need to be adjusted and how big those adjustments will be. If the actual action by the fed is not in line with what the market expected, we can see a very negative impact on the market.
Expectations of # of rate hikes:
If the fed raises rates 4 times a year, that is once a quarter. Any more than that would seem like they are panicking.
Expectation on Size of the hikes:
Hypothetically the market is anticipating an interest rate increase of .25. The Fed announces that they are raising it .50 or double what the expectations were. This “miss” may send the market into a deep dive because the investing community feels that the increase is to excessive.
Conclusion:
The eternal dance of interest rates and the markets is amazing to watch. In many ways controlling interest rates at just the right levels is more of an art than a science. In this post we have explored the case study of the actual fed actions in 2018 and 2019. We explored the positive action that first occurred and then discussed the mistake the fed made. We then explored the reasons why the market sells off when it does. This is a good primer for new investors because it has been a few years since the fed has taken any action. Now as they do, you will understand it much better and be able to make better decisions in your trading.