The Hindu Business Line : Fed rate impact on stocks not on expected lines

The popular belief is that equities are negatively correlated with interest rates. As interest rates move lower, stock prices move higher caused by investors moving funds out of debt (lower yields) in to equities and vice versa. But historic data suggests otherwise. Despite a 25 basis points cut in the Federal Funds Rate on December 11, the Dow Jones Industrial Average (DJIA) moved lower by 2 per cent and the Sensex was almost unchanged.

The federal funds rate is the interest rate at which banks and other depository institutions lend funds to each other in the overnight market in the US. In equity markets such as India, a Fed rate cut is held to be synonymous with a positive trigger as this move is expected to induce US investors to move money out of fixed interest instruments in their country to more lucrative pastures such as emerging markets.

The lukewarm response of equities to the recent Fed rate change might indicate that the domestic equity markets did not relish Fed’s decision as much as the one on September 18. Then, Federal funds rate were cut by a surprising 50 basis point to 4.75 per cent. This was done due to tightening credit conditions which if overlooked would have potentially intensified the sub-prime contagion.

The greater than expected cut in interest rates on that occasion, resulted in the Dow Jones Industrial Average rising by 2.5 per cent. The Sensex too went up by over 4 per cent on the next trading day i.e. September 19.

However, in the recent instance the possibility of Fed rate cut loomed larger than ever before as leading banks and financial institutions have already recorded over $70 billion in sub-prime losses and the US economy is threatening to slide into a recession. This anticipation led to stocks rallying in the weeks leading to the FOMC meeting factoring in the possibility of a 25 basis points cut.

Historical data from 2000 suggests that in the 39 instances when the FOMC tinkered with interest rates, the Dow Jones Industrial Average has not always reacted on expected lines – rising with rate cuts and falling with increases. Investors should not expect equities to react in a copybook manner, akin to that observed after September 18.

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