How the Fed's Rate Hikes Affect the Market (or Not)

In this post, I'll be demonstrating how the Fed's rate hikes affect the equity market (or how they don't), through historical examples and analyses of market psychology. This is an issue that has been going on for a while, and one that has caught the attention of all market participants. Yes, tapering and rate hikes aren’t necessarily good news, but I don’t think that 1) they necessarily indicate the beginning of a bear market/recession, and 2) the Fed is as powerful and influential as we think they are.

This is not financial advice. This is for educational purposes only.

Introduction
- There’s a myth, a misconception in the market that the Fed allegedly rescues falling markets with rate cuts and easing measures, and vice versa for when the market is overheated.
- This myth began in 1987 during Black Monday, when Alan Greenspan’s Fed cut rates after the crash, creating an impression that the Fed was directly responding to the stock market.
- This is when the (mis)belief that the Fed would put a floor under a a falling market stuck.
- Nevertheless, if we analyze the data, it actually demonstrates that the Fed stood pat for most corrections, and cutting cycles typically arrive during bear markets, just as coincidence.

Historical Cases
- There are only two occasions in history where the Fed’s cutting cycles corresponded with market lowpoints.
- The first is the aforementioned Black Monday of 1987, and even for this case.
- If we take a look at the situation back then, it’s not so much that the Fed made international moves that contributed to history, but rather that the bear market started amid a global liquidity crisis.
- With excess liquidity, the rates should have been flat, or down, but that wasn’t the case.
- Thus, the Fed’s rate cuts were vital to unfreezing credit and ensuring banks and clearing houses would have access to liquidity they needed, while the market was under severe stress.
- The second occasion was the rate cut in 1998, when stocks were reacting to the collapse of Long-Term Capital Management (LTCM).
- There was fear in the market that this collapse would lead to a domino effect, ending in a banking meltdown.
- Generally, when people fear a banking contagion, liquidity in interbank funding markets dry up.
- The Fed’s action to cut rates during this time helped keep money moving, and ensured that banks met their regulatory obligations.

Market Psychology
- In order to understand the recent discussion revolving around the importance of the Fed’s actions, we need to understand human nature.
- People love finding narrative threads and grand explanations because we’re biologically wired to make sense of the world that way.
- They confuse correlation and causation, and zero in on evidence that supports their view and shuns whatever suggests otherwise.
- But it’s important to remember that in most cases, a fact that everyone knows, tends to be closer to myth than reality, and even if it weren’t a myth, the fact that everyone knows it does not give us an edge in the market.

Summary
Market shocks are caused by surprises. News about a pandemic or cyber attack that catches investors off guard is much riskier than macro events that are predictable and can be anticipated. Given that the markets are efficient (which I believe they are), it's rational to assume that news about the Fed's rate hikes, and people reaction to it are already priced in. While short term volatility is definitely expected, I believe that the likelihood of this event becoming a trigger for a multi-year recession is extremely unlikely.

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Comment:

***Correction: in 2017, the Fed introduced Quantitative Tightening, not Quantitative Easing.