In an expected but significant turn of events, the US Federal Reserve recently raised the interest rate benchmark range to a staggering 5.25 percent – the highest in over two decades.
Fed’s chair, Jerome Powell, offered a vision of a “soft landing” for the economy, giving hope to some. However, he quickly quashed any hopes of rate cuts this year, causing turbulence in the stock market. While the S&P500 remained stable, ending Wednesday’s trading session flat, the tech-heavy Nasdaq experienced a slight stumble, reflecting the delicate balance of market sentiment.
As the dust of monetary proactive measures settled, the benchmark 10-year Treasury yield showed signs of oscillation, slightly dipping to 3.8 percent after reaching a height of 3.9 percent on Tuesday. Bonds in the United States rode the tide of uncertainty, rising amidst the storm of financial speculation.
The above reading highlights how inflation and the responses to it can impact people’s savings and create wobbling effects on the financial market. Let’s delve into the concept of inflation and examine how the Federal Reserve’s proactive measures can influence the financial market.
1. Fed’s monetary policy impacting debt market
Since 2001, inflation has made a strong comeback in the U.S., compelling the Federal Reserve to consistently implement robust measures to adjust its monetary policy, given that the inflation rate reached levels not seen in over 40 years.
The Federal Reserve’s new policy shift was clearly reflected in the bond market. The yield on the 10-year US Treasury note, an important indicator for the bond market, increased from 1.52 percent at the end of 2021 to over 4 percent this month, marking its highest level in over 10 years.
Simultaneously, the yield on the 3-month US Treasury bill experienced a significant increase, rising from 0.06 percent at the end of 2021 to nearly 5.50 percent in mid-July 2023. These changes in interest rates also had an impact on the stock market.
2. Increasing interest rate impacting equity market
Over the last 30 years, US equities have shown a tendency to grow in value when inflation has accelerated, although the association has not been very strong. Larger firms have a stronger link with inflation than mid-sized firms, and mid-sized firms have a stronger relationship than smaller firms. As inflation rises, the price of foreign equities in developed markets falls, and the price of emerging market stocks falls even further.
However, when interest rates increase, it can impact the stock market in several ways, such as:
Slower Economic Growth: Growing rates can lead to slower economic growth, which can affect the earnings of U.S. companies. When economic growth slows down, businesses may not perform as well, ultimately putting pressure on stock prices.
Attractive Investment Alternatives: Other investment options like bonds and certificates of deposit may become more appealing to investors because they offer higher yields. This can make investors less interested in buying stocks, especially if the outlook for future interest rates remains positive.
Impact on Stock Prices: If a company’s future earnings fail to meet investors’ expectations, their stock prices may go down. This measure is represented by the P/E ratio which means, price investors are willing to pay for a company’s stock relative to its earnings .
This situation took place in 2022 when stocks with high P/E ratios got the hardest hit when interest rates increased, including technology companies and others that performed well during the pandemic.
Higher Borrowing Costs: Higher interest rates could lead to higher borrowing costs for companies, cutting into their profits.
Some companies borrowed money at lower rates in the past, but now they may have to pay more interest on new debt. This could potentially result in lower earnings for these companies and could impact their stock prices as well.
3. Uncertainties in the stock market persist
Amidst multiple interest rate hikes by the Federal Reserve in 2023, the stock market’s future remains uncertain. Fed Chair Jerome Powell has signaled that rates will remain high for an extended period and ruled out any immediate rate cuts. The Fed is striving to strike a delicate balance between economic growth and controlling inflation without triggering a recession.
Nevertheless, there is a glimmer of hope in companies’ performances. If inflation declines, it could prove beneficial for the stock market. While rising interest rates may pose challenges for stocks, there are still opportunities depending on how well companies perform and meet expectations.
Despite the uncertainty, investors must exercise caution and closely monitor corporate earnings in this environment of inflation and high interest rates. Strong company performance and growth potential could have a positive impact on the stock market. However, volatility may persist, and investors should be prepared for fluctuations.
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