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.
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.
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.