It seems that the talking-heads on TV and the print media pundits have turned their focus in earnest toward the Federal Reserve. This is due primarily to the fact that on Wednesday the Federal Open Market Committee (FOMC), which directs U.S. monetary policy, will wrap up its July meeting.
Did You Know?
When it comes to U.S. monetary policy, the Federal Reserve has three key objectives.
- Support maximum sustainable employment
- Support stable prices
- Moderate long-term interest rates.
These objectives are often referred to as the Fed’s “mandate.” The Fed uses four tools to achieve this mandate. One of these tools is influencing short-term interest rates by setting a target for the federal funds rate. The federal funds rate is the rate that banks charge each other for overnight loans. If the Fed believes that inflation is rising or the economy is overheating, it will often try to counteract this by raising the fed funds target rate. Raising this rate causes the economy to slow down or contract. This is due to the fact that higher rates discourage borrowing and spending by consumers and businesses. On the other hand, if the Fed believes that the economy is slowing down or getting weaker or that unemployment is getting too high, they will lower the target rate, which reduces the cost of borrowing and thus spurs economic growth.
At this coming Wednesday’s FOMC meeting, many are predicting that the Fed will vote to reduce the federal funds target rate for the first time in more than a decade. According to the Chicago Mercantile Exchange Group, the fed funds futures market is currently pricing in a 78.6% probability of a 25 basis point cut and a 21.4% chance of a 50 basis point reduction. This means that the futures market places the probability of a reduction of at least 25 basis points at 100%. A basis point is equal to 0.01%. Therefore, 25 basis points is 0.25% or a quarter of one percent. The probability of 50 basis point cut had been much higher, but the better-than-expected June U.S. jobs report released in early July, implied that the economy might be stronger than was previously thought.
What About My Investments?
While the Fed's mandate does not mention the stock market, changes in the Fed’s monetary policy often have an impact on the stock market. Interest rate decisions are often discussed as they relate to bonds and bond prices. Interest rate changes have a direct and inverse relationship to bond prices. This means that as interest rates rise, bond prices fall; and as interest rates fall, bond prices rise. In relation to the U.S. stock market, comments earlier this year by the Federal Reserve Chairman, Jerome Powell, were interpreted by the markets as the Fed would not be raising interest rates any time soon. This caused the stock market to rise.
So, what’s in store for the U.S. stock market if the Fed lowers rates on Wednesday as anticipated? This rate cut comes at a time when each of the major U.S. stock market indices are hitting new all-time highs. Based on research by John Lewis, Senior Portfolio Manager at Nasdaq Dorsey Wright, since 1990, when the Fed has initiated a rate cut when the S&P 500 was within 5% of its high, on average, the index has posted positive returns over the next one, three, six, nine, and 12-month periods. The average 12-month gain was almost 11%. There have only been two occasions where the S&P 500 was within 5% of its high where the market experienced a negative 12-month return following a rate cut. It was a unique time as there were two successive rate cuts in September and October 2007. These rate cuts preceded the global financial crisis. Interestingly, when a rate cut happens when the S&P 500 is more than 15% below its high, on average, the index has posted negative returns over the next one, three, six, nine, and 12-month periods.
What Does This Mean for the Future?
Of course, we can not use this past data to predict the future or even a week from now. It is certainly not a guarantee of what will happen. However, the odds point to a good chance that a rate cut could be a positive sign for the US stock market, as each of the major U.S. stock indices currently sit well within 5% of their all-time highs. On top of this, U.S. stocks remain the number one ranked asset class of the six that I follow on a daily basis. This is definitely not a time to be reducing your allocation to U.S. stocks. Financial goals such as your retirement, should not be influenced by Fed interest rate decisions. Sit tight. Your financial future will thank you.
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