Fed’s Interest Rate Decision and the Stock Market

One of the oldest correlations in financial markets is the one between the Federal Reserve (a.k.a. the Fed) interest rate decision and the stock market.

The rule of thumb calls for stocks or the equity market to rise when the Fed cuts the Federal funds rates, and the fall when the Fed hikes them. But this rule isn’t only valid in the United States.

In every corner of the world, and every financial jurisdiction, the correlation stands true: stocks fall when rates rise, and the other way around.

A few decades ago, before the European Union and the Euro existed, there were more central banks than today, so the equity markets weren’t correlated like today. Moreover, global trade increased rapidly, making the world having a truly global economy.

It is in this economy where the major central banks change the interest rates. And, they all follow in the Fed’s footsteps.

interest rate decision

Take the 2008 financial crisis, for instance. In its aftermath, the Fed lowered the rates to zero.

In fears of a spill off, other major central banks in the world followed suit. As such, Bank of England, Bank of Japan, and the European Central Bank cut their rates too.

But central banks don’t have only the interest rates at their disposable. There’s an entire monetary arsenal to use, and they’ve become more and more creative over the years.

Therefore, in today’s world, we can say that the equity markets rise when the central bank ease the monetary policy. And they fall when the same central banks tighten it.

With the United States being the biggest economy in the world, and the U.S. Dollar being the world’s reserve currency, the Fed’s moves are monitored closely by investors in all corners of the world. From Shanghai to Berlin, and New Zealand to Toronto, all equity markets tremble when the Fed changes the monetary policy.

In some countries the correlations aren’t as acute as in major capitalistic economies, so, perhaps, the name of this article should relate to explaining the stock market movements in capitalistic economies and the interest rate decision and monetary policy changes in the United States.

Coming back to the 2008 financial crisis, the Fed lowered the interest rates to zero, and… the stock market fell even further. The Dow Jones dipped to 6k, and the world seemed to get closer to financial chaos.

Where does this fit into the overall rule of thumb explained earlier? The answer is…cutting rates to zero wasn’t enough. Not even the fact that other central banks in the world did the exact thing, at the same time, didn’t help. More was needed.

And, the Fed delivered. It embarked on a quantitative easing program (it turned out to be four of them, stretching over a few years’ time) that had one single purpose: to ease the monetary policy even further.

Because the interest rates were already to the zero level, the Fed decided to lower the monetary policy further, by using unconventional measures. The stock market’s reaction was supposed to be the same: to rise when monetary policy becomes easy. And, it did.

Conclusion

Fast forward eleven years and here’s where we are: the DJIA (Dow Jones Industrial Average) rose over 24k during this time, with the interest rates in the United States still being “accommodative” (1.25% at the time this article was written).

How about the rest of the world? Equity markets around the world are in record territory with Nikkei in Japan, Xetra Dax in Germany and FTSE 100 in the UK following on DJIA’s steps. There’s little or no sign that the interest rates will rise much further as only gradual rising was signaled so far.

Hence, the equity markets across the capitalistic countries will continue to be supported on dips, if the Fed stays easy. The same should be valid for the U.S. Dollar.

Correlations in the Forex Market

The Forex market moves in a correlated manner. The by-products, the currency pairs, act like being correlated too.

Correlation doesn’t refer only to two or three currency pairs, but also to a currency pair and a different financial product, like a stock index, or a commodity.

Today’s Forex brokers offer more than just currency pairs. Because of the fierce competition between different brokerage houses, every broker tries to differentiate from the crowd.

As such, they offer CFD’s (Contracts for Difference), commodities (gold, oil, silver), and other products like bonds and so one. Depending on the size of the broker and the resources available, a Forex trader has access to different products from different brokers.

Major and Cross Pairs

The first correlation comes from the way the Forex market is organized. Everything surrounds the world’s reserve currency, the U.S. Dollar.

When sovereign entities save their reserves, most of them keep them in American dollars. This makes the Federal Reserve of the United States the most important central bank in the world.

Moreover, it dictates the way the currency pairs appear on the Forex dashboard. As a rule of thumb, any currency pair with the U.S. Dollar in its componence is called a major pair. Every other ones are crosses.

Therefore, the dashboard divides the currency pairs into two parts: major and cross pairs. They have different volatilities and different ranges, even various factors that influence them.

However, they have all one thing in common: they’re correlated.

Of course, not all of them. But, three by three. For every cross moves based on the differences between the two crosses it represents.

Here’s an example the EURGBP cross depends on the moves two major pairs will make: the EURUSD and the GBPUSD. If the two majors won’t move or move the same percentage, the cross will remain flat.

Just like that, any other major pair depends on two crosses. I live you to find out the crosses for every major part of the Forex dashboard.

The Canadian Dollar and the Oil Market

The Canadian dollar moves in a direct relationship with the oil price. That’s normal if you consider the fact the Canadian economy is an energy driven one.

Forex Correlations

More precisely, it heavily depends on the oil price, it employs a lot of people in the energy sector and has one of the most significant oil reserves in the world.

Therefore, when the oil price dips, the USDCAD pair, the most critical CAD pair, will rise. Of course, it will fall when the oil price falls too.

The USDJPY and the U.S. Equity Markets

Perhaps the most interesting correlation is the one between the USDJPY pair and the U.S. equity markets. More precisely, they enjoy a direct relationship.

At different points in time, even the distances traveled are the same, percentage-wise. Some other times, the correlation breaks due to differences in the monetary policies between the two countries, but, eventually, the two markets will become correlated again.

Conclusion

While a correlation offers a healthy perspective over various financial markets, a rule of thumb says that a correlation holds right until it doesn’t anymore. In other words, it may be just a coincidence that two products are correlated for a period.

One thing is for sure, though: the real correlation that exists on the Forex market is the one between the cross and its true majors. If the financial system as we know it today (centered around the U.S. Dollar) exists, this correlation will stand the test of time.