How will a Fed fund rate hike impact equities?

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One of the major questions facing investors is how the US equity market will react if the Federal Reserve decides to tighten monetary policy by hiking the Fed fund rate, i.e. when the “juice” that propelled many strong advances in risky assets over the past few months is removed.

Fed Chairman Ben Bernanke provided some support for stock markets on Wednesday by indicating in his testimony to the US House Financial Services Committee that the Fed fund rate will remain at exceptionally low levels for an extended period. However, the flip side of the coin is his gloomy picture of the economy still battling high unemployment and a weak housing sector.

Although perhaps not imminent, a quick bit of research sheds some light on how a Fed fund rate hike will impact equities when it eventually happens. Over the past 20 years there were three occasions when the Fed increased the Fed fund rate after a period of lowering the rate, as shown below.

sp500-010310

Source: Plexus Asset Management (based on data from I-Net Bridge).

The stock market’s initial reaction in all three instances was a sell-off, with the S&P 500 Index ending down on average by 3,2% after a one-month period. During the second month the market was slightly negative on two occasions (1999 and 2004) but tumbled in 1994. In that year it took seven months for the S&P 500 to return to the pre-rate hike levels, while in 1999 and 2004 it took five months.

tabel

Source: Plexus Asset Management (based on data from I-Net Bridge).

The take-away from this is the fact that after the initial rate hikes the equity market moved higher despite further rate hikes. A lot will depend on the extent to which the US economy can recover in the absence of stimulus and a further inventory adjustment.

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Read more on Federal Funds Rate, Federal Reserve at Wikinvest
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