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.

Explaining the Forward Guidance Principle

Between two central bank meetings, an economy changes for good or for worse. A central bank’s job is to interpret the economic data released between two meetings and set the monetary policy for the period ahead.

forward guidance

The time interval between two central bank meetings differs around the world. In the United States, for example, the Fed meets every six weeks. The same in the Eurozone, where the ECB (European Central Bank) also meets every six weeks.

Australia and the United Kingdom differ. The two central banks use monthly and assess the state of their respective economies.

When the ruling bodies of these central banks meet, they don’t just set the interest rate, but the overall monetary policy. Moreover, sometimes they only make sure that the economy goes smoothly, and they re-assure the market participants that everything follows a plan.

That’s forward guidance: the process of communicating to the market the next moves in such a way that no turbulences appear.

It’s not an easy task. In fact, central banks were forced to implement such measures due to the increasing importance of high-frequency trading.

High-Frequency Trading and Forward Guidance

Robots dominate trading these days, both regarding the number of orders executed, and, recently, regarding “thinking” and interpreting future market moves. Such robots or trading algorithms run thousands or more trades per second (sometimes even per millisecond), with the intention of profiting from the slightest market move.

As such, the time frames became so small that the classic pattern the human eye sees, won’t do the trick in this world. There’s no head and shoulders or rising wedge pattern visible on the one-second chart, or even lower.

If the retail traders buy and sell on trading accounts with five digits on most currency pairs (even though the 4th digit is still the one that defines a pip), for trading algorithms things look fundamentally different: they trade on the 7th digit, or even more.

Because of these algorithms and the increase in the number of trades they execute, the market fluctuated more and more in the recent years. As such, something had to happen. Enter Fed.

The Federal Reserve of the United States Moves

The Fed was the first bank to introduce the term, and the concept known today as the forward guidance principle. Its move was a bold one.

It introduced a press conference to follow every second Fed meeting. During the press conference, the Chairwoman/Chairman, explains the FOMC (Federal Open Market Committee) Statement takes a question from the press representatives.

During the press conference, it provides “forward guidance” on the next Fed moves. That’s all that matters for the Forex market as it moves based on future expectations.

A recent example happened when the Fed started the so-called quantitative tightening program (selling the bonds bought under the quantitative easing program). At the press conference, Mrs. Yellen described the process as “boring as watching an oil paint dry.”

And so, it turned out so far, with little or no reaction from the market. It means the Fed provided the right forward guidance, and the market wasn’t surprised by the move.

Conclusion

Other banks quickly followed in the same footsteps. The first one was the ECB (European Central Bank).

It changed the number of meetings in a year (from once a month to once every six weeks) and added the forward guidance.

In fact, central banks did what retail traders had to do for years: adapt to the constant changes in the Forex market.

Euro and the ECB

Yesterday’s ECB (European Central Bank) meeting was the main event of the week. All eyes were on Draghi and the monetary policy conditions to be announced.

As such, the Euro was in focus starting with Monday. And, it didn’t disappoint.

For the whole summer, the EURUSD pair moved in an almost vertical line. It rose from 1.05 to 1.20 in less than five months.

Euro

While such moves are not uncommon in the Forex market, they’re not that common for a dollar pair. Many traders tried to fade the move and sold new highs. However, new buyers stepped in on each and every dip.

But why would the EURUSD surge so dramatically?

The Interest Rate Differential

One reason would be the interest rate differential. The only thing is, it should have favored the dollar. Not the Euro.

While the interest rate in the United States rose to 1%, it is still negative in the Eurozone. As such, the interest rate differential should favor the U.S. dollar. Not the Euro.

Yet, the EURUSD pair rose dramatically. The thing is that Forex traders focus on expectations more than on the actual situation.

And, for the whole summer, the signs from the Eurozone economy were positive. Unemployment dropped, GDP (Gross Domestic Product – the total value of goods and services) rose, industrial production as well, PMI’s look good…all signs of a strong and healthy recovery.

Because of that, trader’s expectations grew that the ECB will react. And, that the Fed won’t do anything moving forward.

As such, if the ECB will start tightening the monetary policy (reducing the size of the quantitative easing program), the interest rate differential will shrink. And that’s what drove the Euro higher.

This Week’s ECB Meeting

To many people’s disappointment, the ECB didn’t deliver. Not that traders expected new measures to be announced this week.

But, at least a hint at what’s about to come. Instead, the ECB chose the path of least resistance. Let’s sit and wait and see what will happen.

All bets are now on the October meeting. It is supposed to bring a schedule for the ECB to reduce the bond buying program.

This, alone, is bullish for the Euro. Will send the EURUSD skyrocketing higher. However, only if the Fed won’t change anything. But this is unlikely.

Comes Fed into Discussion

Following the 2008 financial crisis, the Federal Reserve of the United States (Fed), embarked on various monetary policy programs. All destined to ease the monetary conditions.

As a result, the dollar weakened. Moreover, the Fed’s balance sheet increased exponentially.

Now, the Fed started to tighten the monetary policy. It hiked the interest rates four times, lifting it from zero to 1%.

Furthermore, it vowed to start unwinding the balance sheet. Therefore, it will start selling the bonds in its portfolio.

Of course, this will be a gradual process. But, it has a tightening effect on the monetary policy.

Conclusion

No matter how you put it, the Fed seems to be, again, ahead of the curve. While the Euro buyers base their trades on future expectations, dollar bulls look at what happens with the Fed’s actions.

However, there’s one wild card that doesn’t shows up neither in Eurozone nor in the United States. That’s inflation.

If, when and were inflation will pick up first, that’s where the money will flow. Because expectations will grow that the respective central bank will tighten the monetary policy faster. Hence, the cost of money will rise.