When the Federal Reserve raises interest rates, it affects more than just your mortgage and savings rates – it can have serious ramifications on your investment portfolio as well.
Nominal profits and risk premiums can be easily understood; however, the impact on sentiment states may come as a surprise – yet this remains a key driver behind stock market reactions to unexpected Fed policy surprises.
1. Lower Interest Rates
Interest rates play a crucial role in driving the stock market. When interest rates on certificates of deposit (CDs) and Treasury bonds fall, investors will move their money from them into stocks; this capital movement can cause prices of those stocks associated with the market to go up as investors diversify into other investments.
Lower interest rates can benefit companies that pay dividends by helping them afford to borrow more for expansion and growth, consumer spending also receives a boost, and rising or falling interest rates have an effectful influence over price-to-earnings ratios that ultimately determine investors’ decisions to buy stocks.
Additionally, the Federal Reserve’s ability to manipulate interest rates — cutting them when economic growth needs an injection and raising them when inflation threatens — can have an effect on investor trust in the stock market and encourage consumers and businesses alike to spend more – leading to future earnings increases and therefore stock prices.
2. Lower Inflation
When the Federal Reserve indicates a rate hike, consumers and businesses could react by cutting spending or investment plans – leading to earnings decline and stock price decrease.
But if the Fed signals an interest-rate cut, consumers and businesses may spend more, raising profits and driving stock prices higher. Since stock markets tend to focus more on what will come next from the Federal Reserve rather than on what has already happened, such actions could cause major shifts.
The stock market is an invaluable way of forecasting economic activity, so it should come as no surprise that the Federal Reserve uses it as part of their monetary policy to set federal funds target rate, discount rate and collateral held by them – this system controls liquidity available to financial institutions (banks, credit unions and savings and loans) when purchasing. Furthermore, its actions influence expected profits as well as risk premiums which affect expected profits and risk taking behaviours.
3. Higher Earnings
Stocks tend to rise with corporate profits, which is why an increased price-earnings ratio can often be seen as an indicator of market success.
But when earnings growth falls short of offsetting rising interest rates, investors lose enthusiasm – thus explaining why stock markets’ gains since the coronavirus outbreak have been somewhat muted.
Positively, higher wages, consumer spending and capital investments continue to bolster company bottom lines, and that inflationary threats don’t threaten stocks yet.
Furthermore, many investors believe the Federal Reserve has enough flexibility to adjust interest rates if the economy falters – an expectation which could help propel markets higher in the near future, particularly sectors that have lagged like small caps, lower quality consumer cyclicals and regional banks.
4. Increased Spending
The Federal Reserve’s target interest rates directly impact borrowing costs for banks and consumers alike, so when they lower those rates it can encourage people to spend more, which in turn boost corporate earnings and stock prices.
Changes in target interest rates generally take at least a year to have any substantial economic ramifications; however, the stock market typically reacts more swiftly when news breaks about them. That’s why it is crucial for investors to closely watch when the Federal Reserve releases policy statements, especially those concerning interest rate directions.
If the Fed unexpectedly lowers interest rates without warning, this can send stocks plunging due to expectations about rate cuts already being built into asset prices. Effective communication by the Federal Reserve could help mitigate this effect; but remember, not just interest rates are under their purview – they also control longer-term bond yields like those found on 10-year Treasury notes.
