Much Ado About Interest Rates

Interest Rates: Love them, hate them, or just don’t understand them; their current impact on the financial market is indisputable.

Last week, the S&P 500 index was all but poised to hit its all-time high of 3,000; thwarted ironically by news of a strong jobs report signalling a healthy economy. This in turn led to a minor sell-off in the stock market. So what gives? Why are investors seemingly interpreting good economic news as bad news and bad economic news as good news? It appears that up is down and down is up in the navigation of the topsy turvy world of Federal Open Market Committee Meetings and Federal Fund Interest Rates.

To start with, the federal funds interest rate refers to the interest rate that banks charge other banks for lending them money from their reserve balances on an overnight basis. The Federal Open Market Committee (FOMC), the monetary policy-making body of the Federal Reserve System, meets eight times a year to set the target federal funds rate. The FOMC makes its decisions about rate adjustments based on key economic indicators that may show signs of inflation, recession, or other issues.

The Federal Reserve (Fed) can be dovish or hawkish in setting monetary policy. A hawkish stance is when a central bank wants to guard against excessive inflation. Central banks don’t want the economy to grow too quickly, because it is not sustainable. So they try to keep the economy growing at more reasonable pace by being hawkish, or watching over inflation like a hawk. They usually do this by raising interest rates. When money becomes more expensive to borrow, it slows the growth of the economy because it makes it harder for businesses to grow by using borrowed money to expand, and people will spend less through borrowed money, like credit cards.

Dovish is the opposite of hawkish. This is when an economy is not growing and the government wants to guard against deflation. In other words, they want to do something to stimulate the economy. In order for people to start spending more money on goods and services, the central bank will usually lower interest rates. Remember, doves fly lower than hawks. When it is easier (cheaper) to borrow money, businesses can expand more easily and consumers will usually spend more money by using credit cards or other types of debt, to finance purchases.

Last year, the two biggest anchors of the stock market were the Sino-American Trade War and the Fed interest rate hikes. In September, following a series of hikes, the Fed raised interest rates by 25 basis points to current levels, the highest recorded since April 2008. On January 30, 2019 the Federal Reserve said that it would keep its target range for its benchmark interest rate at 2.25% to 2.5%, the range it had announced at its meeting on December 19, 2018.

The Fed’s hawkish stance was continuously criticized by President Donald Trump, which ultimately led to a catch-22 for Federal Reserve Chairman Jerome Powell. Powell faces difficulty in adopting a dovish stance because there is now the perception that he may be bowing to political pressure rather than making decisions based on the underlying economic performance data.

This week, the S&P 500 managed to momentarily surpass the 3,000 target after news of weak economic data, because that news gave investors hope that the Fed would take a dovish stance and cut interest rates amid the uncertainty of the economic outlook. Powell himself also signalled that a July rate cut remained on the table despite the strong jobs report of last week.

So as it stands, the Fed interest rate policy has more bargaining power on the market’s movements than the fundamental economic data. It’s a counter-intuitive dynamic in which investors experience schadenfreude at the economy’s weakness and a sense of gloominess when the economy appears to be in good shape.

Why are investors waiting with baited breath for a rate cut? The U.S. is currently in the longest economic expansion on record, and historically the stock market has always rallied after the first rate cut when the economy isn’t in a recession, data shows.