Interest Rates and the Stock Market

In his ten-minute speech at the annual Jackson Hole Economic Symposium on Friday (8/26/22), Jerome Powell made it clear that the Fed is not messing around. They plan to raise rates until inflation is well under control.

Following his comments, the market went into a free fall finishing down 3% on the day.

Just as it seemed that the market was on its way back up following one "good" inflation report (as defined by it not worsening), it appears that many investors had miscalculated Powell's soft-landing philosophy in assuming that the worst of interest-rate-tightening was over. Clearly, it is not.

The question I keep hearing is why the market reacts so negatively to these announcements?

With the acknowledgment that the market is wildly complex with many factors impacting its direction, I think understanding the risk/return trade-off and how interest rates affect the economy might help answer the question above. Here we go.

The Risk/Return Trade-Off:

Let's imagine that investors can achieve a return of 3% on a risk-free basis. This being the case, there are a certain number of investors who prefer this guaranteed rate. And then there are others who will seek the additional potential return that other asset classes (such as stocks) may offer. For sake of this example, let's call 3% our equilibrium point.

Now let's imagine that rates suddenly drop from 3% to 1%. When this happens, fewer people will accept just 1% on their money and may now prefer the additional potential return the other asset classes, such as stocks, may offer.

Generally speaking, this causes the market to rise, which helps explain why the market went on a tear to close out 2020 and continued into 2021 when rates dropped to almost zero.

Unfortunately, as you have probably guessed, the opposite is also true. When rates rise, investors who were comfortable with stocks may now prefer the new higher rates and sell their stocks in response, causing prices to fall.

And when rates rise quickly, as they have thus far in 2022, stocks can get pummeled as a result. This makes sense. But there's more to it.

Interest Rates and the Economy:

In the complex, adaptive system that is the economy, changes in interest rates impact other aspects of the business cycle that impact the stock market further. For instance, interest rates impact employment, business growth, the expediency of cash flows, and much more.

Generally speaking, rising rates slow business growth and cash flows and increase unemployment, amongst other things. Not surprisingly, these negative effects can cause recessionary fears to spike. And as you know, when fears rise, markets generally fall.

Where We Are Today:

As it stands now, we are experiencing both of these scenarios at once. Investors are weighing their investment options given higher rates while recessionary fears are becoming more evident. And rightly so. But when this happens abruptly, the result is often significant downward pressure on the market, causing days when the market collapses as it did on Friday.

This is why everyone is on pins and needles every time Powell speaks.

But I'll say this. I'll take short-term market volatility over rampant inflation any day of the week because we have built financial plans that are prepared to handle volatility and bear markets.

The alternative of semi-permanent rampant inflation could cause many financial plans to blow up, so I hope the Fed stays focused on getting inflation under control even if that means more short-term pain will come. That doesn't make it fun, but this is the way I'd encourage you to look at it as well. In the end, this is the better of the two options.