Fed Policy: Why Do Rates Hikes Hurt Stock Markets?

Fed Policy: Why Do Rates Hikes Hurt Stock Markets?

On December 18th, the Federal Reserve announced a rate hike of 25 basis points. For the U.S. economy, this is the fourth increase of 2018 and it brings the Fed funds rate to a range of 2.25% to 2.5%.  The move came despite strong opposition from U.S. President Donald Trump, and equities prices fell quickly in response to the decision.

Dow Jones

As a clear indication that investors are also unhappy with the move, stock markets are now set to close the 2018 in negative territory for the first time since 2009.  So, what exactly is the reason stocks tend to fall when central banks raise interest rates?

Reasons Central Banks Raise Interest Rates

In order to understand why rate hikes tend to weigh on stock markets, we first need to understand why a central bank might want to raise interest rates in the first place.  The first part of the equation can be found in consumer spending habits, which tend to increase whenever lending costs are low. This makes it cheaper to utilize credit cards or to take large loans from a bank.  But with any credit purchase or loan agreement, there is a chance that the borrower will not repay the balance due.

Banks and credit card companies compensate for these risks by charging interest rate fees to their customers. When a central bank keeps interest rates low, it is easier for these banks and credit card companies to offer access to cheap credit agreements.  In most cases, this inspires an increase in consumer spending activity. This stimulates the economy and raises stock valuations for the company’s with improved earnings results which occur due to the rise in consumer spending.

low-interest

In the chart above, we can see some of the effects interest rate policy can have on consumer spending within the broader economy.  The period which followed the 2008-2009 financial crisis was characterized by record low interest rate levels. This action from the Fed generated strong gains in consumer spending within most asset classes.  Even major purchases like automobiles and homes benefited from the trend, as reduced lending rates made credit agreements easier to make large purchases.

Conversely, when interest are high, consumer spending activity tend to slow because the cost of credit is more expensive.  This typically reduces corporate earnings performances and creates a lagging effect in broader economic metrics like national GDP growth.  The negative sentiment which is created by these expectations also tends to dampen the optimism which is required to generate bullish rallies in the stock market.  

When this occurs, important benchmarks like the S&P 500, NASDAQ, and Dow Jones Industrial Average often see declines.  In the chart above, we can see why this tends to be the case. During policy tightening cycles at the Federal Reserve (grey bars), we tend to see a slowdown in mortgage applications, credit card spending, and automobile purchases.  This is because lending costs make these purchases more expenses, and the reductions in consumer spending will generally weigh on corporate earnings. As a result, stock valuations tend to fall sharply during these periods.

The Fed’s Market Outlook for 2019

Earlier in the year, the Federal Reserve released several public commentaries which suggested a strong possibility for three interest rate increases in 2019.  With inflationary pressures stable and the unemployment rate low, annualized prospects for GDP growth remain relatively robust from the historical perspective.

This positive economic activity gives the Federal Reserve some extra leeway in terms of its ability to continue raising interest rates until they reach more normalized levels.  If this does occur, we could see additional volatility in the stock market as slower earnings growth starts to eat away at the potential for upside momentum. In any case, we can see that the Federal Reserve wields a great deal of power in macroeconomic environments which are characterized by hawkish changes in monetary policy.  For these reasons, investors will continue to pay close attention to the next set of clues which will be released by the U.S. central bank in the months and quarters ahead.

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