On September 21, 2022, the Federal Reserve hiked benchmark interest rates by 75 basis points in a spirited attempt to bring down the runaway inflation. Currently, the August 2022 rate of inflation in the US as measured by the Consumer Price Index (CPI) stands at 8.3%. Food and fuel prices are the leading categories, pushing up inflation to levels last seen in the 1980s.
In the United Kingdom, the Bank of England raised interest rates by 2.25% to try and contain the worst inflation in four decades. In August, inflation in the UK stood at 9.9% pushed up by food prices, energy bills, and fuel.
The interest rate and stock markets have an inverse relationship. When the benchmark interest rate raises the stock markets will get affected. The reaction of the stock market towards rake hikes is interesting and important to watch. Investors are always keen to anticipate market movements in light of interest rate hikes by central banks. Read on to understand the anatomy of these rate hikes and what they mean for you as an investor.
What Are Benchmark Rates
Also known as reference rates, benchmark rates refer to interest rates that reflect the cost of credit in different markets. In the United States, the top benchmark rates are:
- Effective Federal Funds Rate (EFFR)
- Overnight Bank Funding Rate (OBFR)
- Secured Overnight Financing Rate (SOFR)
- Broad general collateral rate (BGCR)
- Tri-party general collateral rate (TGCR)
These rates are calculated by the Federal Reserve System to help enhance efficiency in market functioning.
Why Raise or Lower the Base Rate?
When the Federal Reserve hikes or lowers the base rate, it sends a signal to commercial and other lending institutions to review their rates as well. This mechanism is part of the monetary policy intervention by central banks.
The Federal Reserve, acting in its capacity as the fiscal agent for the US government, constantly monitors the state of the economy including the price level. A rise in the price level above the targeted rates means the economy is heating up and needs to be cooled down. For instance, the current target inflation rate is 3% to 3.25%. However, the prevailing inflation is at 8.3%.
In response, the Federal Reserve is hiking the benchmark rates to influence the rates at which banks lend thus increasing the cost of credit. When this happens, consumers reduce their borrowing levels consequently cutting down demand and lowering prices. Businesses also lower their production levels and slow down the wheels of economic growth.
The Effect Of Interest Rates On The Stock Market
A rise in interest rates usually dampens the stock market and vice versa. Here are the different mechanisms through which rate changes are transmitted.
Interest Rates and Business Investments
Businesses borrow to invest in the production of goods and services. When interest rates increase, the cost of new debt increases, and the cost of servicing existing debt depending on its structure may also increase. This lowers business activity, reduces sales, increases operational costs, and lowers profitability.
Reduced profitability means firms may struggle to reinvest in the future and pay out dividends. This combination makes their shares less attractive to investors leading to a fall in price.
Reduced Appetite for Consumer Credit
Consumers shy away from accessing new credit during periods of rate hikes. The cost of existing debt may also go up thus leaving very little financial space for discretionary spending. This behavioral shift affects retail sales and the profitability of firms. Again, it transmits into reduced profitability and cashflows, which makes share prices less attractive.
What Should Investors Do?
In a market environment where rates are rising, investors have several options they can explore as they watch out for pockets of opportunities. Here are some ideas on what to do.
Diversify Their Portfolio
Bonds and stocks normally move in opposite directions. In times when rates are rising and stocks are falling, investors should add more fixed-income securities -federal, corporate, and mortgage-backed securities. They can also look at Real Estate Investment Trusts (REITs) which often do well in inflationary environments.
Load More Resilient Stocks
Utilities and banking stocks have proved over time to be resilient to interest rate hikes. These stocks perform well even when the economy is reeling from the effects of rising inflation.
Short Selling
When stocks are falling, you can decide to take short positions on certain stocks. For instance, you may short tech stocks. This strategy involves borrowing an asset to sell high and waiting for it to fall and buying it low. Using derivative instruments such as Contract for Differences (CFDs) and spread betting, you can short-sell stocks in a straightforward way. However, short selling can lead you to huge losses unless you put in place measures such as stop loss.
Conclusion
Interest rate movements affect how the stock market reacts. On one hand, a rise in rates often dampens the market and leads to a fall in share prices. On the other, a fall in rates leads to increased business activity, profitability, cash flows, and a rise in share prices. Through instruments such as CFDs and bonds, investors can shield their portfolios against losses during volatile times and even profit in the process.
