Surprise, but When Fed Hikes Rates, Markets Rally
Conventional wisdom tells us that when the US Federal Reserve hikes rates, stocks fall. But is this true? Here is a piece I wrote for Business Standard that describes this in some detail. 
 
In mid-January, Fed announced that it would adopt an aggressive stance to control interest rates, after the consumer price index had climbed 7% in 2021, the largest 12-month gain since June 1982. 
 
As everyone now knows, global markets started falling sharply as everyone feared that the US may be forced to announce interest rate hikes to combat inflation. But does Fed rate hike lead to market fall? One way to understand the probable outcome is to simply examine what happened in the past when the Fed hiked interest rates. 
 
Surprise, but the S&P500 index has averaged a 9% return in 12 rate-rising cycles since the 1950s and the market has gone up on 11 of them. Sometimes older data becomes irrelevant due to structural changes in the economy and 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%. There were nine rate hikes from 0.25% to 2.5% from December 2015 to December 2020. 
 
How did the S&P react? It went up non-stop, from around 1900 in December 2015 to 2800 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 Fed hikes interest rates, markets do not fall, they rise. 
 
What explains this? Usually, the Fed hikes rates in response to stronger economic growth. When the economy is doing well, corporate profit grows. 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 makes 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 economic growth and corporate profits.
 
By the same logic, markets fall at the end of the rate hikes. Remember, the Fed hikes rates to cool an overheated economy. 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 the economic growth is moderating. Sometimes, the Fed is seen to have gone too far and too late in stopping rate hikes. When growth slows down, against the backdrop of high rates, the market reacts negatively. 
 
What about inflation, to control which, the Fed is seen as hiking interest 5-7 times in this year? Yes, if high inflation persists, the Fed will indeed increase rates to higher levels but as of now, inflation is due to supply shocks, not scorching demand. 
 
I cannot 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 down, the Fed may even stop, after a couple of rate hikes. 
 
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