What will happen to the market after the Fed meeting?

Federal Reserve has a very strong role in shaping the U.S. economy and the stock market. Fed's recent price cut decisions have always sparked strong reactions in the stock market. Today, we will analyze the reaction of Federal Reserve decisions on the stock market.

Understanding the Federal Reserve

The United States central banking system, famously known as the Federal Reserve System, was initially created on December 23, 1913. Fed consists of 12 regional banks. Fed's responsibilities are governing monetary policy, supervising financial institutions, and maintaining the stability of the banking and financial system. Fed uses tools like the federal funds rate (FFR) and open-market operations to influence the economy to achieve its dual mandate: price stability and maximum employment.

Recent Fed Actions

The Federal Reserve has made headlines with its recent decisions and signals. To keep the economy afloat during the COVID-19 market crash, the Fed drastically reduced the interest rates, eventually resulting in a remarkable V-shaped recovery of the economy. The S&P 500 bounced back from a steep drop and reached all-time highs. Feds employed another method, which involved purchasing government bonds and securities to improve liquidity in the banking system.

However, the situation is evolving since The Fed has started tapering its asset purchases to reduce economic stimulus. Simultaneously, the central bank has hinted at raising interest rates to combat inflation, a shift from its previous stance. These actions have generated volatility in the stock market, which we've witnessed in 2022.

Impact of Interest Rates on Stocks

One of the most significant ways the Federal Reserve influences the stock market is through changes in interest rates. The primary tool, the federal funds rate (FFR), impacts borrowing costs. Lower interest rates, as seen during the pandemic, make borrowing cheaper, encouraging both consumers and businesses to invest and spend more.

Conversely, a higher FFR means a more expensive cost of borrowing. This translates into reduced access to cheap capital for growth investments for businesses. Consumers face higher interest rates on car loans and mortgages, which can lead to reduced spending. Thus, interest rate hikes tend to dampen economic activity and have a corresponding impact on stock market sectors and types of stocks.

Sector-Specific Responses to Interest Rate Hikes

Not all stocks react the same way to interest rate hikes. Different sectors and types of stocks have distinct responses: When interest rates rise, certain sectors tend to be more resilient. Companies in the consumer staples, energy, financial, and utilities sectors often outperform. These industries are considered defensive or noncyclical, as their products and services are in demand regardless of economic conditions. It is necessary for the economy for people to be able to buy essential items (food, beverages, household products, and utilities).

Technology and consumer sectors are more vulnerable during interest rate hikes. Businesses associated with these sectors usually require substantial capital for growth, which makes them sensitive to changes in the cost of borrowing. Small-cap stocks can also be disproportionately affected because they are more growth-oriented and capital-dependent.

Historical data supports these observations. During restrictive, rising-interest-rate environments, stock returns tend to be more muted compared to expansive periods. The divergence in performance between defensive and cyclical sectors becomes evident in such times.

Recent Market Response to Fed Signals

Every signal from the Federal Reserve has triggered reactions in the stock market. Fed's recent decision to keep rates unchanged while simultaneously suggesting the possibility of a rate hike later in the year created shockwaves in the market. The Fed's dot-plot projections indicated that its policy rate target could remain above 5% through 2024. The yields of short-term Treasury bonds went up, due to which the U.S. dollar became stronger, and due to these reasons, the stocks received negative growth.

After the announcement by Fed chairman Jerrome Powell, the Nasdaq Composite dropped nearly 200 points (1.5%). This shows the vulnerability to rising interest rates of growth-oriented sectors. The S&P 500 also dropped by 0.9%. Dow Jones Industrial Average, a value-oriented stock exchange, also experienced a more modest decline, but only 0.2%.

Conclusion

The Federal Reserve's decisions and signals regarding interest rates profoundly impact the stock market. Understanding how different sectors and types of stocks respond to interest rate changes is crucial for investors. Defensive sectors tend to fare better during rising interest rate environments, while cyclical sectors, especially technology and small-cap stocks, can face challenges.