What the Fed is Going On?

If you’ve taken a look at the stock market recently, you’ll notice some poor performance. This is because investors are afraid of the Federal Reserve’s (the Fed) change in policy. The Federal Reserve is a private bank that essentially sets the interest rate. The Fed is the reason why your savings account is paying nothing, and also why the stock market recently reached an all-time high. In fact, these two events are related.

 

In the wake of the recent sub-prime crisis, the Fed lowered interest rates to stimulate the economy. Investors reacted. Since interest rates in savings account were low, some investors moved their money into other assets, assets they hoped would generate a higher investment return: specifically stocks. This increased demand for stocks drove up stock prices, creating the all-time market high. In short, stock prices have been artificially inflated because of low interest rates.

In previous posts, correlation was discussed. Consider how interest rates are correlated with stock valuation. As interest rates decline, stock prices shoot up – resulting in over-valued securities.

Now, the Fed made the announcement recently that it will be reversing course – that is, raising interest rates. With higher anticipated interest rates, those temporal stock market investors have made the decision that their money is better off in a savings account – which eventually should be paying a higher interest rate than what is being offered right now.

 How much will the market decline? This depends upon the Fed’s next move – how much interest rates rise.

What does this mean for the investor? Expect a market decline in the short-term.