As Fed hikes rates, will markets rally?

No, there is nothing wrong with the heading, even though conventional wisdom tells us that when the US Federal Reserve hikes rates, stocks fall. The Indian market has been under great pressure ever since US inflation rates started rising late last year. After a long phase of zero interest rates, investors have been worried that the US Federal Reserve will hike interest rates. These fears came true in mid-January, when the Fed announced that it would adopt an aggressive stance to control interest rates after the consumer price index had climbed 7 per cent in 2021. This was the largest 12-month gain since June 1982. On February 10, the inflation rate hit 7.5 per cent and the global markets fell sharply again, worried that the US may be forced to announce a 50 basis point hike in interest rates as an emergency measure. The Fed has also been shrinking its holding of government bonds and mortgage-backed loans. The immediate fallout of these steps, according to conventional wisdom, is that money would move out of risky assets like stocks. Will it? One way to understand the probable outcome is to simply examine what happened in the past when the Fed hiked interest rates. 

It is a fact that the S&P500 index has averaged a 9 per cent return in 12 rate-rising cycles since the 1950s and the market has gone up in 11 of them. Sometimes older data becomes less relevant due to structural changes in the economy and the markets. So, let us look at the more recent data. The Fed hiked rates 17 times from mid-2004 to mid-2006. And yet, during those rate hikes, the S&P500 rallied 46 per cent. There were nine rate hikes from 0.25 per cent to 2.5 per cent from December 2015 to December 2020. How did the S&P react? It went up non-stop, from around 1,900 in December 2015 to 2,800 in December 2017. The index wobbled in 2018 at the end of the three-year rate hike cycle — not at the beginning. After the Fed cut rates in August 2018, the market went up again before the Covid-driven crash in March 2020. In effect, when the Fed hikes interest rates, the markets do not necessarily fall.

When even recent history indicates a positive correlation between rate hikes and US indices, not the inverse, why does everyone believe that stocks swoon when the Fed hikes rates? I have no idea; I guess it is intuitive to think that if money, which is the market’s fuel, gets dearer, the markets would tumble. But there are other forces at work also, which explain why stocks rise when rates rise. Usually, the Fed hikes rates in response to stronger economic growth (a symptom of which could be higher inflation). When the economy is doing well, corporate profits grow. If corporate profits grow, stocks rise. Stocks don’t really care about our conventional wisdom. As the economy expands, the Fed hikes interest rates bit by bit. If growth continues to be strong, we get higher profits and higher stock prices, which make the Fed hike rates again, and so it goes on. This explains why we see a cycle of rate hikes and rising stock prices. The connection is strong between economic growth and corporate profits.
 

Interestingly, by the same logic, the markets can fall at the end of the rate hikes. Remember, the Fed hikes rates to cool an overheated economy (whether there is a strong correlation between interest rates and economic growth in every situation is another matter, but that is the orthodox idea). But even if rates dampen an overheated economy, it takes time for this to play out. After all, producers will not stop production to meet higher demand just because the Fed has hiked rates. When the Fed stops hiking rates, though, it is a signal that economic growth is moderating. Sometimes, the Fed is seen to have gone too far. When growth slows —whether due to rate hikes or other reasons —the market reacts negatively. Often, the Fed steps in to cut rates and boost growth, which it did in August 2018, and the markets took off again. The Fed’s actions are flexible.

Are there any exceptions to a situation of rate hikes leading to higher stock prices? After all, macroeconomic events have too many unseen and moving parts, which can be explained only with the benefit of hindsight. The exception is this: When growth is slowing but the Fed continues to hike interest rates or refuses to cut them, stocks will fall. What about inflation, to control which the Fed is seen as hiking interest rates five-seven times this year? Yes, if high inflation persists, the Fed will indeed increase rates to high levels as Paul Volcker did when US inflation hit 14.8 per cent in March 1980. But as of now, it is hard to see how, in a globally connected world, with continuous productivity improvement and cost reduction due to technology, inflation can stay stubbornly high in mature economies. If inflation cools, the Fed may even stop after a couple of rate hikes. 

Is this why the Reserve Bank of India (RBI) continued with an accommodative stance last Thursday? Perhaps there is no reason to be trigger-happy about interest rates yet (marginal hikes in rates anyway do not affect the economy either way). Ending his comment on the monetary policy, the RBI governor used Lata Mangeshkar’s famous song Aaj phir jeene ki tamanna hai, stressing the “eternal message of optimism”. Who knows, if the inflation rate goes down and the Fed doesn’t have to hike rates, his optimism may turn out to be sagacious.

The writer is the editor of www.moneylife.in 

Twitter: @Moneylifers