Is Fed Easing Actually Good for the Market?

Feb 18, 2008: 10:40 AM CST

Is it really as simple as “When the Federal Reserve cuts rates, it’s great for the market” or “When the Fed raises rates, it’s bad for the stock market”?

Michael Panzer of Financial Armageddon recently asked this question, as well as provided an excellent graph detailing stock market returns and Federal Funds rate at his post “Is Aggressive Fed Easing Really Bullish for Stocks?

This is a concept I’ve been at odds with the financial media for quite some time, but I felt alone in my view.

Traditional thinking goes like this:

“When the Fed raises rates, it chokes off money supply through higher interest rates and decreases capital expansion, so it’s bad for the market. However, when the Fed lowers rates, it’s great for the market for the opposite reason. With lower cost of carry rates and lower interest payments, companies can take on more loans and expand their business, as well as the consumer can purchase more items (including bigger purchases like houses and cars) on credit or loans (or mortgages).”

That’s absolutely true, but what does it mean when the Fed raises or lowers rates?

Typically, the Federal Reserve raises interest rates to prevent rampant inflation from runaway expansions caused by ‘easy money.’ If the Fed kept rates at 1%, then so many businesses would be expanding and consumers would be spending that inflation (through higher demand) will cause everyday prices to skyrocket as well.

The Federal Reserve lowers interest rates to stimulate a weakening economy to encourage businesses to expand and consumers to spend. If weak economic conditions are present, or predicted through fundamental forecasts, then the Fed typically will choose to reduce rates to stimulate expansion.

That’s excellent, but let’s look at some of the underlying facts behind this:

The Fed raises rates when business conditions are “too good” and the economy is expanding or is expected to expand.

The Fed lowers rates when business conditions are “too bad” and the economy is contracting or is expected to contract.

How does that relate to the market?

The Stock Market generally rises when businesses conditions are good and the economy is expanding.

The Stock Market generally falls when business conditions are poor or deteriorating.

Keep in mind that the stock market anticipates economic conditions (discounts them) by a factor of three to six months in advance.

So what might it actually mean (in simplified terms) when the Fed raises or lowers rates?

When the Fed raises rates, it means economic conditions are good, and the stock market is expected to rise.

When the Fed lowers rates, it means economic conditions are poor (or becoming so), and the stock market is expected to fall.

Before you scream “foul,” let’s look at the excellent 10 year chart from Michael Panzer that expressed this sentiment far better than any words could:

(Image Credit: Financial Armageddon)

Notice that the market (S&P 500) was rising into 2000, and interest rates were rising as well.

Notice that the market began to stumble in 2000, and then fall, and Interest Rates fell right alongside the market.

Notice how the market bottomed in 2002/2003, and as the market rose through 2004-2006, the Federal Funds rate rose as well.

Finally, notice how the market fell in 2007/2008, and the Federal Funds rate fell as well.

Also, notice the flatline periods in the target rate. This indicates likely turning points in the campaign by the Federal Reserve, but also indicates long-term investment shifting points from into the market and out of the market.

A simple strategy (that flies in the face of conventional wisdom) might be buy stocks when the Federal Reserve is in a campaign of raising rates and be in bonds (which rise as rates fall) when the Federal Reserve is in a campaign of lowering interest rates.

The next time you hear a Wall Street pundit scream because the Fed raised rates, or jump with jubilation because the Fed lowered rates, think back to this chart and what that actually means.


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Comments
  • John,

    If you bought bonds the day the Fed slashed rates, your bond portfolio would be up around 7% - 10% (not to mention the six months of interest payments), while your stock portfolio would be down possibly greater than 7 - 10%. See my post today (Feb 19, 2008) for a relative performance chart between the two.

    Recall that the Fed can only control overnight interest rates - not the 30 year rate directly. Also, recall that bond prices react to a whole other set of variables, including inflation rates/perceptions and perceived economic conditions. Rate cuts have spiked inflation, and bonds also may be forecasting an economic recovery (hence their price decline) as yields have slowly pushed up over the last few weeks.

  • Andrew,

    Thank you.

    That's an excellent question. In the past, the Fed reacted to the economy moreso and now it seems like the Fed (Bernanke especially) is a bit more reactive to the market. It was not a coincidence that the day the stock market was set to open up 5% down the day after global markets fell as much as 7% that the Fed surprised Wall Street with the biggest cut in 25 years. Wall Street seems to be like a crying baby begging for more candy, and when you give it more, it wants more still.

    Of course, the market does react to the Fed, but if the market doesn't get what it wants from the Fed (if it wanted a .50 cut and got a .25 cut), then it will sell off. Of course, unexpected positive surprises often result in upward swings as well.

    It's a 'conundrum.'

  • John

    Buy bonds hasn't quite worked this time around -- at least with the long bond. It's been selling off since the last rate cut.

  • Andrew Palladino

    Very interesting post!!

    The question here is whether the Fed is reacting to the market , or the market is reacting to the Fed?

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