The US Federal Reserve's chief, Jerome Powell, recently raised the alarm across equity markets by signaling that the US central bank plans to further hike interest rates to keep runaway inflation under control. This announcement has caused concerns among equity market participants, who believe that most of the interest rate hikes are behind us, with the central bank already having hiked interest rates to their highest level since 2008 at 4%.
The US Federal Reserve's interest rate hikes are a highly watched event in the financial world because they have significant impacts on the US economy, including the stock market and equity sectors. In this article, we will take a closer look at the implications of rising US Fed rates on the stock market and various equity sectors.
Why Does the US Central Bank Keep Interest Rates Higher?
Interest rates refer to the cost of borrowing money from a bank or other financial institution. The Federal Reserve is responsible for setting interest rates in the US. When the economy is growing and inflation is rising, the Federal Reserve raises interest rates to slow down economic growth and prevent inflation from getting out of control. Conversely, when the economy is in recession or experiencing slow growth, the Federal Reserve lowers interest rates to encourage borrowing and investment, which stimulates economic growth.
Interest rates are adjusted through the Federal Open Market Committee (FOMC) meetings, which are held eight times a year. During these meetings, the FOMC reviews economic data and decides whether to raise, lower, or keep interest rates unchanged.
The US economy faced soaring inflation trouble as the coronavirus pandemic led to high supply disruptions across the globe, pushing prices higher. In order to control this soaring inflation, the central bank hiked interest rates continuously to calm inflation pressure. However, due to the constant rise of rates, recession fears began to crop up, which led equity markets to drop.
What Happens to the Stock Market When Interest Rates Rise?
The stock market can be volatile, and many factors can impact its performance, including interest rates. When the Federal Reserve increases interest rates, it becomes more expensive for companies to borrow money, and this can negatively affect their profitability. Higher interest rates can also cause investors to shift their investments to bonds or other fixed-income securities, which can lead to a decline in the stock market.
However, the impact of rising interest rates can vary across sectors. For example, financial institutions, such as banks and insurance companies, typically benefit from rising interest rates as they can charge more for loans and earn higher returns on their investments. On the other hand, utility companies are often negatively impacted by rising interest rates as they require a lot of borrowing to fund their operations.
The Nasdaq 100 index, which tracks the top 100 technology companies in the US, recently dropped 2.5% due to pressure from rising interest rates. In 2022, it ended lower by 33%. Rising interest rates can also negatively impact the real estate sector as it can make it more expensive for people to borrow money to buy homes or commercial properties.
History Lesson
The Federal Reserve increases interest rates to combat inflation, which can hurt the economy. In the 1970s, the central bank faced a similar outbreak of hot prices and increased rates at a fast pace, with the policy rate rising 4.5 percentage points from near zero. To many officials, the fact that inflation has been slow to respond to higher rates, while the economy has continued to grow, was evidence that rates needed to move higher still.
However, on March 10, 2023, the country's 16th largest bank failed, which raised concerns about the stability of the financial system. For Fed policymakers, this episode raised the possibility that they had repeated a mistake they had sworn to avoid and gone too far in raising rates. Economists began marking down their growth forecasts, anticipating that banking stress means a credit contraction lies ahead, with less money in the pockets of homeowners and businesses.
Goldman Sachs analysts expect that stress on smaller banks could result in a tightening of lending standards, exerting an incremental growth drag on gross domestic product of as much as a half point. Markets are hardly settled, and the Fed has announced a review of its supervision at the bank that failed to see if warning signs were missed.
What Should Investors Do?
As an investor, it's important to keep an eye on interest rate hikes and how they may impact the sectors in which you have investments. Some sectors, such as financials, may benefit from higher interest rates, while others, such as utilities, may be negatively impacted. It's also important to have a diversified portfolio that can weather market volatility.
Investors can also consider working with a financial advisor who can help them navigate market fluctuations and develop a long-term investment strategy. A financial advisor can help investors understand how rising interest rates may impact their investments and adjust their portfolio accordingly.
Interest rate hikes by the Federal Reserve can have significant impacts on the stock market and equity sectors. While rising interest rates can cause a decline in the stock market, the impact can vary across sectors. As an investor, it's important to keep an eye on interest rate hikes and how they may impact the sectors in which you have investments. Working with a financial advisor can also help investors navigate market volatility and develop a long-term investment strategy that aligns with their goals and risk tolerance.
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