As widely reported, the Federal Reserve Board in December raised interest rates by 0.25% for the first time in 2016 and only the second time in a decade. The DJIA fell by 100 points immediately after the announcement, but their action signifies confidence in the improving US economy. Back in 2008, rates were slashed to near zero in the midst of the financial crisis and eventual recession. Since then, unemployment has fallen to 4.7%, the lowest rate since 2007, and the economy has continued to grow for 7 years, albeit at a slow pace.
With new incoming administration comes plans for big spending on infrastructure that would spark demand for many goods, typically a precursor of inflation. Fighting inflation would involve raising interest rates at a faster pace in the next year, which the Fed has hinted at. However, as we saw in early 2016, hints create no certainty with the Fed. Last January they projected raising rates 4 times in 2016 until low oil prices and other economic setbacks put those plans on hold.
But if this rate hike reflects a strengthening economy, shouldn’t the stock market rejoice with a spike instead of the 100-point dip in the Dow? Raising interest rates creates a domino effect in the behavior of consumers and businesses that ultimately impact the market. The immediate effect of raising the federal funds rate is that it makes it more expensive for banks to borrow from the Fed. Banks then increase the rates they charge to customers to borrow money for mortgage or credit cards. This decreases the amount of disposable income that consumers can spend. If consumers spend less, business have lower revenues and profits. Additionally, if it becomes more expensive for businesses to borrow from the bank, they may borrow less money, slowing their growth and decreasing profit. Simply put: a decrease in profit for companies lowers the stock price of a company and if enough companies experience these declines, the whole market would go down.
Conventional wisdom suggests that when interest rates fall, fixed income investments are less competitive because of lower yields and stocks become more attractive; conversely, when rates rise, fixed income investments are more attractive because of higher yields. That is not to say that rising interest rates automatically result in dropping stock prices and falling interest rates mean more profit for companies. One of the reasons the Federal Reserve raises interest rates is to keep inflation down, which is good for businesses and may cause stocks to rise. This time around, however, things are actually different. Rates were at historic lows, and the Fed has never raised interest rates when inflation has been as low as it is today. But interest rate hikes typically occur during favorable economic conditions, and history shows that stock prices can keep going up despite interest rate hikes. Below, you will see that between 2004 and 2007 the stock market was at record highs, even with rising interest rates.
An investor cannot invest directly in an index. The opinions and forecasts expressed are those of the author, and may not actually come to pass. This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation of any specific security or investment plan. Past performance does not guarantee future results.