How The Stock Market Typically Reacts To Central Bank Policy


The U.S. Federal Reserve announced on Wednesday another 0.25 percent federal funds rate, which, when translated from Fed speak, means they hiked interest rates. Traders know that interest rates are an important variable when it comes to financial markets, but the immediate impact of monetary policy decisions on financial markets can be a bit more nuanced than it may seem.

Here’s a look at how the market typically reacts to central bank policy, and what it may mean if it reacts differently.

Dovish And Hawkish Decisions

Interest rate hikes and other policy decisions made to counter inflation at the expense of economic growth are known as hawkish policies. Lower interest rates and other policies intended to stimulate inflation and economic growth are known as dovish policies.

In general, rate hikes are bad news for stocks because higher interest rates raise the cost of borrowing for public companies. Not only does that higher cost of capital eat into earnings, it also discourages companies from borrowing money to invest in growth projects.

Interest rates are also inversely correlated to bond prices and commodity prices, meaning higher interest rates put pressure on both of these markets.

Higher interest rates tend to be good for financial sector stocks, especially banks. Higher rates allow banks to charge higher rates on loans and expand their net interest margins.

However, higher interest rates are generally bad news for high-yielding stocks, such as real estate investment trusts, utilities and consumer staples. Higher yields on lower-risk Treasury Bonds and bank CDs tend to lure dividend investors away from the relatively risky stock market.

Predictability Makes Things Complicated

The scenarios described above are centered on the fundamental impact that rising rates have on asset classes, market sectors and individual stocks. However, the knee-jerk market reaction to central bank policy decisions often has little to do with long-term fundamental market changes.

The Federal Reserve and other central banks typically do everything they can to avoid jolting financial markets with their policy changes. To accomplish this goal, the Fed and other central banks try to be as transparent and predictable as possible when it comes to their decisions. Language in public statements is carefully chosen to make it relatively easy for investors to read between the lines at the direction future policy is headed.

Expectations Are Key

By being intentionally predictable, the market can adjust to policy changes slowly in the weeks and months leading up to the changes, rather than violently reacting to the changes in a single day. For example, prior to Wednesday’s announcement, the bond market was already pricing in a 96.3 percent chance of a rate hike, according to the CME Group FedWatch tool. With that level of certainty already priced into the markets, it’s understandable that the immediate market reaction may not be very pronounced, or even discernable at all, in certain cases.

Traders should look out for any policy changes that deviate from general market expectations. It’s those decisions that break from expectations that potentially create the biggest near-term trading opportunities.

Lime Brokerage LLC is not affiliated with these service providers. Data, information, and material (“content”) is provided for informational and educational purposes only. This content neither is, nor should be construed as an offer, solicitation, or recommendation to buy or sell any securities. Any investment decisions made by the user through the use of such content is solely based on the users independent analysis taking into consideration your financial circumstances, investment objectives, and risk tolerance. Lime Brokerage LLC does not endorse, offer or recommend any of the services provided by any of the above service providers and any service used to execute any trading strategies are solely based on the independent analysis of the user.

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