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.

Ascending and Descending Triangles in Forex Trading

Forex traders say that “the trend is your friend” in the currency market. In other words, they try to ride a trend for as long as possible, buying dips in bullish ones and selling spikes in bearish trends.

The problem with this approach is that the market doesn’t trend that much. It depends very much on the currency pair and the period considered.

Of course, any EURUSD trader that was bullish this 2017 will argue that the pair was in a stable trend for most of the year. It rose from 1.05 to over 1.20 in less than six months, in an almost vertical line.EURUSD.iDailyThe problem is that the market doesn’t form such trends often. Moreover, even during trends so strong, it takes time to consolidate, to build energy before breaking, higher in this case.

Rookie traders will argue that this is the easiest trend to trade. Simply stay long until the channel breaks.

I tend to argue with them. Because the enemy to a trading account is the trader him/herself, staying long on this time frame (daily) isn’t easy.

Traders face a tough decision in the fear/greed play: to close the position/positions before the weekend or to keep them open.

Ascending and Descending Triangles

To be more exact, this bullish trend took over 130 days. During this time, there were a few weeks where the intraday/intraweek price action was extremely bearish. That’s where the trend consolidates and when triangles form.

If the triangle breaks in the same direction with the underlying trend, it is called an ascending triangle (in a bullish trend) or a descending one (in a bearish one). Effectively, the price builds energy to break in the same direction.

Let’s zoom in the previous EURUSD chart:

eurusd chart

We see that for over twenty-three (23!) days, the price didn’t do anything. It merely consolidated on the horizontal.

You can say what you want, but the truth is that the psychological factor in trading will see many of retail traders closing the previous long trades, booking the profits, and most of them even going short for whatever reasons.

If you add the fact that the EURUSD has a negative swap for trades kept open overnight, few retail traders bear to pay that small interest on a trade, for almost a full month.

Yet, the market formed a classic ascending triangle: a bullish pattern that only sees the price building energy around a horizontal line.

That horizontal line isn’t mandatory to look like in the chart above. The notion of an ascending or descending triangle comes from the stock market, where the patterns were identified for the first time.

Due to the higher volatility on the Forex market, the price rarely hesitates and consolidates around a horizontal line. Instead, the line has a slightly ascending or descending angle, keeping the notion of an ascending or descending triangle alive.

Conclusion

Ascending and descending triangles are continuation patterns. Keep in mind that the Forex market, despite the impression it gives, it consolidates most of the times.

When this happens, like it does in over 65% of the cases, a triangle forms. Triangles are the favorite way for the market to consume time, and they can be either reversing or continuation patterns.

If the trend continues in the same direction, an ascending or descending triangle formed. All traders must do is to correctly interpret the break and jump on a trade when the trend resumes.