Relationship between rate hikes and equity markets
Interest rates and equity markets usually have an inverse relationship. The relationship is not a perfectly inverse one but its impact is usually seen in the long run. Let’s consider the recent past. The Fed has been consistently raising rates since December 2015, and at the same time, equity markets (SPY) in the US and across the globe scaled new peaks. This is an exception because the US real interest rates have fallen below zero and even now stand at a low 1.25%. The inverse relationship comes into effect once the interest rates are back to the normal long-term average levels between 3% and 5%.
Why equity markets react to interest rates?
When interest rates are increasing, consumers scale back on borrowing that fuels purchases, which impacts demand and thus dents the revenue of the companies whose stocks trade on the markets (QQQ). The opposite is also true when interest rates are low. People borrow more and purchase more, and revenues increase.
Will the Fed’s rate hike projection impact equity markets?
If the US Fed in its September meeting signals another rate hike in December, there could be some knee-jerk reaction in the equity markets, but the impact might not be sustained. The rate hike might not be due until December and the probability of a hike stands just above 50%. Rate-sensitive sectors like banking (XLF) and insurance (IYF) could witness some volatility (VXX) during and after the FOMC statement, but the overall market is likely to remain buoyant.
In the next part of this series, we’ll understand why bond yields have rebounded from their lows after the uptick in August inflation.