Recently, the stock market held its breath as the Federal Reserve prepared to announce whether they would hold short-term interest rates at the same level or cut interest rates by 25 or 50 basis points. The announcement by Federal Reserve Chairman Jerome Powell that the Fed would hold interest rates at their current level caused stocks to rally. Wall Street was even more excited because the statement released by the Fed hinted that the Fed would be likely to cut interest rates following their next meeting in July.
This was only the latest in the natural tension between Congress, Pennsylvania Avenue, Wall Street and the Federal Reserve that shows up every month when the Federal Open Market Committee’s (FOMC) Board of Governors meets to discuss the current and future direction of the short-term Federal Funds rate – which they announce at the end of each meeting.
Why do investors care about the Federal Reserve?
Investors became very familiar with the Federal Reserve at the depth of the financial crisis which introduced the phrase “too big to fail” into the national discussion and led to the creation of “quantitative easing” and stress tests for banks that were geared to removing systemic risk and provide financial stability to our nation’s banks. At that time, the Fed lowered interest rates to a level between zero and one percent in order to stimulate economic growth.
The Fed funds rate is the benchmark rate that banks and other financial institutions use to set the prime rate that determines interest rates on mortgage loans, car loans, personal loans, credit cards, and student loans. Just a small move of one-quarter of one percent can cause the stock market to rise and fall by hundreds of points. Most of this activity occurs in advance of the Federal Reserve Board’s meetings as one Fed board member or another expresses their opinion about the need for, and the likelihood of raising, lowering, or maintaining rates. In June of 2019, when Wall Street was lobbying the Federal Reserve to lower interest rates, Zack’s said: “The market is pricing in a 97% certainty that at least one rate cut is coming this year, with others (analysts) speculating that we could see as many as two or three.”
The Federal Reserve looks for a Goldilocks policy
Wall Street will always want the Federal Reserve (the Fed) to react swiftly to economic indicators and tighten or loosen monetary policy as appropriate. However, the Fed’s goal is to have an economy that is neither too hot nor too cold. The Fed pays close attention to leading economic indicators (sometimes referred to as data in hand) to measure the level of economic activity in the nation particularly as it relates to employment and wages. Both of those indicators speak to consumer spending which accounts for 70% of the economic activity in our country. Because economic indicators can be either leading or lagging, the interest rate direction set by the Fed is usually not reactive to the immediate data but uses it as a predictor of future economic activity.
The Fed can either have an accommodative monetary policy, a tight monetary policy or a neutral policy. An accommodative policy is considered good for equity investors. An accommodative policy includes lowering lower the federal funds rate, which makes it easier for businesses and consumers to borrow money, thus stimulating the economy and boosting unemployment. A tight monetary policy is generally a bearish signal for equities. To cool down the economy, raising interest rates can increase the cost of borrowing. This can also have the effect of raising the unemployment rate. Since the Federal Reserve is non-partisan, their mandate to keep the economy and the nation’s money supply stable can run counter to the overall trend in the stock market. Holding rates steady can be either positive or negative depending on analysts’ expectations.
The takeaway for investors is clear when the Fed speaks, Wall Street listens. The President of the United States and Congress also pay attention and make statements and craft economic policy that telegraph their opinion on their preference to a tighter or looser monetary policy. In recent years, this has caused some analysts to question if the Fed is as “non-political” as their mandate suggests.
How much should investors care about the Federal Reserve?
Investors are caught in the middle of this push and pull between financial markets, the U.S. government and the Central Bank. But the question for investors is how closely investors should allow the Federal Reserve’s decision on interest rates affect their investment decisions. For equity investors, rising interest rates have a direct correlation to lower stock prices and lower bond yields. However, income investors, who have a higher percentage of their portfolio invested in cash, can benefit from the higher interest rates. When interest rates are lower (as they have been for several years), equity investors benefit as stock prices and bond yields tend to rise. However, a low-interest rate environment can be difficult for income investors who will not see much growth in their portfolio and may have to take on a higher level of risk to get the return they need.
While seeing the stock market rise and fall sharply can be unsettling, the answer of what to do with your money comes down to the type of investor you are. For active traders, like day traders, the announcement of interest rate hikes can be a time to take aggressive action to take advantage of short-term price movements. However, for many investors, it is best to realize that the market prices in a higher or lower interest rate before the Fed’s announcement. It is best to follow your investing plan. A good investment will not stop being a good investment because of the Fed's activity. Likewise, a bad investment will not survive a short-term “propping up” if their fundamentals do not support the upward move.