In second half of December 2018, the stock market experienced lots of uncertainty. With the market being up one day and down the next, speculators do not know how to position themselves. It looks like volatility is back and it is there to stay. The news that really shook up the market was the federal reserve increasing the interest rates, along with the partial government shutdown. I personally think that increasing interest rates have a bigger impact on the market than the partial government shutdown. So, in this blog post, I’ll talk about how interest rates influence the stock market.
The Federal Reserve drops interest rates when it is trying to jump start the economy after a stock market crash. As the economy improves, the Federal Reserve starts increasing (hike) interest rates. This way, when the next recession does happen, the Fed can drop the interest rate and stimulate the economy. How does decreasing interest rates stimulate the economy? People are more likely to borrow money if the interest rate is near zero. Wouldn’t you buy/finance a new car or a new house if the interest rates are near zero? As you start spending money, the economy starts improving. Currently, we are in the phase where the Fed is increasing interest rates. What does this mean? The Federal Reserve hikes interest rates when it thinks that the US Economy is healthy and has a brighter future. Hiking interest rates can be tricky, since rapidly hiking interest rates could lead to deflation. Why do you think the stock market dropped after the Federal Reserve decided to increase interest rates by 25 basis points? Here is my take on the recent decline:
- The Federal Reserve ended Quantitative Easing (money creation) in 2014, and in the past couple years, the Fed has started to hike interest rates. As the Fed starts tightening (supply of money decreases), it is harder for companies to borrow money. Furthermore, as interest rates increase, companies are less likely to borrow money since they have to pay interest on that borrowed money. (Why do companies borrow money? To expand/grow quicker. ) As companies borrow less, growth slows, profits lessen, and the downturn begins.
- According to one of the main concepts to the Dow Theory, the market discounts everything. So, the Fed’s expected decision should have already been baked into the market. A lot of traders buy on anticipated news, and sell on actual news. This means that once the news is released, traders get out of the trades. Based on this logic, the market should have turned negative once the Fed decided to increase the interest rate.
- I think that it’s good news that the Fed hiked the interest rates, since it means that they find the US Economy to be performing well. As the stock market starts getting overpriced and the interest rates increase, nervous investors want to move from stocks to bonds. I did notice that the US 10 Year Treasury Yield has decreased to 2.716% (December 30) from the November high of 3.241%. What does this mean? It means that the bond prices have increased – indicating the flow of money from the stock market to the bond market.
- As 2018 comes down to an end, with a limited number of trading days left in the year, traders tend to give their losers one last chance before they execute their trades. I believe that as the market started spiraling down, traders (who want to minimize their existing losses) cashed out. Traders will be claiming those losses (Capital Loss Deductions) to offset their income when they file for taxes.
- I noticed that as Jerome Powell, the chair of the Federal Reserve, started speaking, the market started tumbling further. In my opinion his tone was a bit dovish – he indicated uncertainty and said that the Fed is highly data dependent. Market could have seen this as the Fed saying that they expect the economy to weaken. Again, this is my opinion of why the market dropped further.
Hope you learned a little and found this blog post helpful. We talked about the relationship between rising interest rates and the stock market. As always, you can sign up for our mailing list here. Like us on our Facebook page here. Thank you!
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