Why does the stock market, despite the prospect of higher interest rates?
The prospect of increasing interest rates has the stock market on edge.
The Federal Reserve, the United States’ central bank, will likely raise its benchmark interest rate many times this year to rein in persistently rising inflation. On Wednesday, Fed chairman Jerome Powell reaffirmed that likely.
The action would raise borrowing prices for companies and consumers from near zero — where they have been since the start of the Covid epidemic. Have you ever heard of California loans? Check Oak Park Financial.
Stocks have taken a dip in January as a result of the prediction.
The S&P 500 index is down nearly 9% year to date. This week, the basket of US equities fell below 10% for the first time since March 2020’s early pandemic turbulence. The index fell 0.2 percent Wednesday after Powell’s speech, wiping off previous gains.
A more temperate economy
Why is the stock market so concerned?
The causes seem to be twofold: a slowing US economy and the likelihood of other assets such as bonds becoming more appealing than equities.
When the Federal Reserve increases its key interest rate, banks and lenders often increase borrowing charges. Mortgages, credit cards, and other forms of debt become more expensive, decreasing consumer spending and demand. Additionally, businesses pay a higher interest rate on their debt.
This, in general, dampens corporate profit expectations and dampens investor excitement for purchasing their shares.
“A tightening of monetary policy would put downward pressure on economic activity,” says Blair du Quesnay, a certified financial planner and investment adviser based in New Orleans with Ritholtz Wealth Management. “And it is deliberate.”
Too far, too quickly?
The Federal Reserve’s “design” is to contain inflation. In December, consumer prices increased by 7% year over year, the most effective rate since 1982.
However, the stock market is not responding just to the prospect of a rate hike; stock gyrations are also influenced by uncertainties about how quickly the Fed will accelerate.
“What the market despises is quick shifts in the monetary environment,” says David Stubbs, global head of cross-asset thematic strategy at J.P. Morgan Private Bank.
When inflation started to accelerate in early 2021, Fed officials said it was most likely a transient phenomenon caused by a hyperactive economy rising from epidemic dormancy.
Their tone has evolved in recent months as inflation has remained far over the Federal Reserve’s long-run objective of 2%. This seems to be mainly because customer demand for tangible items outweighs supply, while Covid continues to upset businesses.
“Since the December meeting, I would estimate that inflation has been about constant, if not somewhat worse,” Powell said Wednesday. “I believe that if the situation worsens, our policies will have to address it,” he continued.
Investors are concerned that a strong Fed reaction would brake the economy – despite Powell’s assurances that the policy response will be “nimble.”
According to CFP Lee Baker, founder of Apex Financial Services in Atlanta, market jitters are caused mainly by anxiety over that result.
“How would the Fed’s rate hikes affect the rest of the economy if it goes too far, too fast?” What effect does it have on [business] profits if it slows the economy? You just follow the domino,” Baker said. “If you’re discussing profits, you’re discussing stocks.”
(This discussion is based on a representative sample of US equities. It is not true that all businesses would suffer if interest rates increase. For example, some may do better, a bank that charges a higher interest rate on loans.)
Stocks lose their luster.
If interest rates increase, investors may place a higher premium on bonds, certificates of deposit, and other less risky assets than equities.
Since the 2008 financial crisis, yields on such conservative assets have been relatively low, resulting in a lengthy era of ultra-low interest rates to stimulate the economy.
Baker said that investors seeking profits were virtually “pushed” into equities.
The value proposition may shift if bond yields and CD rates rise in lockstep with the Fed’s benchmark rate.
Though it seems to be the primary one, the Fed policy is not the sole factor for investors to be nervous about.
For starters, there is the possibility of conflict between Ukraine and Russia. These geopolitical tensions add to the uncertainties — for example, how may war affect the energy sector?
Du Quesnay added the stock market selloff might be beneficial, regardless of what caused it. The Federal Reserve is considering raising interest rates due to the economy and labor markets; a decline in stock prices may also help bring inflated business values more in line with reality, she said.
“When you exclude all external news and information about the stock market, it has increased by double digits for three consecutive years,” duQuesnay. “Perhaps, despite everything else, it should be sold.”