If you are watching the stock market, you may have seen a strong bullish trend during the COVID-19 pandemic as well as a bearish trend over the past years. For many people, these movements may not make sense because the market seems to soar while most of the world is on lockdown and is not doing great once everyone gets back to their workplaces. To understand why the stock market moves this way, we should discuss how interest rates affect the stock market and what the Federal Open Market Committee (FOMC) is.
How Interest Rates Relate to Stock Market
The stock market has an inverse relationship to interest rates. There are many different ways investors value stock prices, and most of the valuation techniques take into account interest rates. One simple way to value a stock is to discount all future cash flows by a certain discount rate. Usually, the discount rate is a combination of a risk-free rate and a risk premium. If the risk-free rate increases, then all future cash flows are discounted at a higher rate, which may make the stock less attractive.
When interest rates increase, the risk-free rate also increases, which leads to stocks being less attractive. This may lead to a decrease in value for most of the stocks. When the investors see that the stocks lose value, they choose to sell them to protect themselves from the downside. When there is more selling activity and not enough buying activity, the stocks decrease their prices.
It is important to note that not only interest rates drive stock prices. Advancements in technology, which lead to higher earnings, and general competition may also affect stock prices. Generally, it was expected that the stocks would decrease during the pandemic because the companies could not produce enough, and they would not be able to make enough profits. On the other hand, the low-interest rates offset the decrease in earnings by decreasing the discount effect of all future profits. The interest rates can be influenced by the Federal Reserve Overnight Rate, and the Federal Open Market Committee (FOMC).
How FOMC Affects Interest Rates
The Federal Open Market Committee usually meets eight times a year to decide the monetary policy adjustments including the Fed’s Fund Rate target. During the FOMC meeting, the committee can decide what market operations they can undergo as well as what overnight rate they should set. Fed’s Fund Rate is the rate at which commercial banks can borrow and lend money to the Federal Reserve. This is considered the lowest rate available for the economy. All other interest rates are based on the Federal Funds Rate.
When the Federal Reserve increases the overnight rate, it translates to higher interest rates for government bonds that are considered risk-free. Once the bonds adjust their interest rates, the investors adjust their financial discount rate, which will change the value of the stocks. From this point, the investors make a decision whether to sell or to keep the stocks, which will drive the stock prices.
The Federal Open Market Committee can also do market operations such as buying and selling government bonds. When they sell government bonds, the prices of the bonds decrease, which leads to an increase in the interest rate that they pay. When interest rates on the bonds increase, investors may prefer buying bonds instead of buying stocks, which leads to a further decline in stock prices.
How FOMC Affected the Stock Markets
In the beginning of the pandemic, the stock market dropped more than 30% in just a few days. The Federal Reserve decided to step in to save the economy by decreasing overnight rates to effectively 0% as well as they launched a large bond purchasing program to decrease the interest rates for government bonds. Once they proceeded with their plan, the stock market started to recover rapidly, and it grew throughout the years 2020 and 2021. It peaked at the end of year 2021.
Once the pandemic was over, the Federal Reserve faced another struggle. An abnormal market activity that is partially caused by the FOMC actions has led to a higher-than-expected inflation rate. At that point, the FOMC changed its objective from stimulating the economy to trying to tame inflation.
To lower the inflation rate, the Fed had to change its monetary policy in the opposite direction. Instead of stimulating the economy with low-interest rates, they had to cool it down with higher interest rates. On March 16th, 2022, the FOMC announced its first rate hike since the beginning of the pandemic, and it also provided the market with signals that the rate hikes will continue.
Expectations play an important role in stock market valuations because if investors expect a higher interest rate in the future, they will account for their expectations. The Fed clearly indicated that they are planning to increase the overnight rates up until the point when there is clear evidence that the inflation rate is decreasing. Since the beginning of the rate hikes, the overnight rate has moved from 0% to 3.75%, and the Fed still signals for future rate hikes.
It is unclear when the Fed will pivot from its current policy, but it is clear that its current objective is to lower the inflation rate in the United States. The best way to understand how and why the markets currently move is to follow the FOMC meetings, inflation data, and unemployment data provided by the Bureau of Labor Statistics.