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How the world’s most influential central bank impacts markets

  • Understand why the US Federal Reserve is so important.
  • Describe the way that different factors affect both the US stock market and the US Treasury market.
  • Identify the way that interest rates affect economies and market returns.
CPD
Approx.30min
How the world’s most influential central bank impacts markets
Photo by Karolina Grabowska from Pexels

The US Federal Reserve is the world’s most influential central bank. When it makes major policy decisions, the impact is felt across the globe. 

So, it was no surprise the Fed’s recent announcement that it will begin raising interest rates in March prompted such anxiety among investors about the impact on financial markets.

To assess whether this anxiety is justified, we examined the performance of the US stock market, Treasury bond market, and the US dollar in the six and 12-month periods after the beginning of each Fed hiking cycle since 1974.

We chose these time periods because we believe they represent the minimum investment horizons investors – rather than speculators or traders – should consider when making tactical investment decisions.

US stock market typically performs strongly

It turns out that for nearly five decades the US stock market has tended to perform strongly after the Fed has begun a new hiking cycle. Out of the 21 rate hike cycles during the period we examined, the US equity market delivered a positive total return 17 times – this is a hit rate of 81 per cent – in the 12 months after the first hike, and 16 times in the six months after the first hike, which is a 76 per cent hit rate. Since 1984 the hit rate is 100 per cent, with a positive total return during all 11 rate hike cycles in the six and 12 months after the first increase in policy rates. 

This is somewhat counterintuitive. When rates are raised, financial conditions become tighter, the cost of capital and of borrowing increase, and the discount factor used to calculate the present value of future cash flows rises, leading to lower stock prices – all else being equal. However, interest rate cuts tend to occur during periods when the economy is weak and rate hikes are typically made when business activity enjoys an upward trend and inflation is elevated or rising.

Rate hikes and a strong economy

The beginning of rate hike cycles usually coincides with a relatively strong economy, which in turn is supportive of a buoyant equity market – hence the usual strong performance of stocks in the period immediately following the rate hike. If rate rises continue, however, tighter financial conditions could eventually adversely impact stocks. Rate hike cycles tend to start with a strong performance of the stock market over at least the first 12 months, but this performance may turn negative if the cycle is prolonged.

Does this mean we can expect positive stock market performance in the year following the beginning of the next hiking cycle? Here, we must be cautious, context is important. For example, one consideration our analysis does not take into account is the unconventional monetary policy that the Fed has been widely using since the 2008 global financial crisis.

Monetary policy levers such as quantitative easing, tapering asset purchase programmes and quantitative tightening, forward guidance, and other monetary measures may have taken away some of the impact interest rate changes have on markets, or, at a minimum, improved the Fed’s ability to signal forthcoming rate rises to investors.