The possibility of the Fed increasing interest rates is probably the most discussed topic in the Financial Markets and media. Interest rates have become the Damocles’ Sword of every investor, which is the fear that the stock market faces deep declines when the interest rate hike will take place. This fear leads to the phenomenon when bad economic news becomes good news for the Market with the rational that the Fed will delay its decision to hike interest rates.
The timing and the percent rate increase has become a major topic in the financial media where numerous analysts can, at best, only confuse the average investor because every opinion on this topic is negated by another analyst with a different opinion. Perhaps the most important topic for the investor is not so much when interest rates will rise but what will be the Market’s reaction to the increase.
Surprisingly, there is very little discussion or data to indicate how the Market will respond to the increase. The consensus is that the Market’s volatility will increase. This is not very helpful for the investor who has to decide whether to stay invested or run to the exit or how to reposition his/her portfolio.
In reviewing the literature, we did not find any empirical studies that address this issue. We were able to obtain historical Fed fund rates from the economic research of the Federal Reserve of St. Louis.
We examined historical data in order to learn how the Market reacted in the past to changes in the Fed fund rates after 10, 30, 60 and 90 days from when the change took place. The goal was to determine if we could use the Fed rate and rate change as predictors of whether the Market (SP-500) will be higher or lower after the interest rate change.
Using a logistic equation, we estimated the probability that the Market will be higher or lower after the rate change.
From this table we can learn that the rate change was not a statistically significant variable.
In order be significant at the 95% level, z<-1.96 or z>1.96. The only significant variable was the Fed rate, hence the higher the rate before the increase, the more likely it is that the Market’s reaction will be negative but even if it was significant, the short-term effect was small. After 90 days the increase in the Fed rate had a positive sign, hence there was no evidence of a negative impact on the Market.
By using the logistic equation, we find that after a rate increase of 0.25%, which is expected in December, the probability that the Market (SP-500) should be higher is 50% after 10 days, 64% after 30 days and 72% after 90 days.
Historial data suggests that an increase of 0.25% occured 234 times and, on average, the Market response to this increase did not show any significant change. Ninety days after the rate change, the Market was up 1.4%.
If historical data of Fed interest rate increases is a guide for future Market response, then one should not be afraid of the upcoming rate increase of 0.25%. It is possible that the Market will be lower after the rate hike but this could not be attributed to the rate increase.