One of the truisms that has developed in the stock market over the last decade is that the Federal Reserve matters more to stock prices than just about anything else. More specifically, monetary policy will impact market sentiment, causing stocks to rise or fall accordingly. The relationship is quite simple and, for the most part, maps well onto history: higher interest rates mean lower stock prices and lower interest rates mean higher stock prices. Meanwhile, quantitative easing and any kind of fiscal stimulus (the Fed’s bond buying programs, mostly) will also cause prices to rise. Quantitative tightening (selling bonds, lowering the Fed’s balance sheet) will do the opposite.
There is not a direct mechanistic relationship between the two phenomena. While many think that the Fed literally inserts money into the market that is then used to buy stocks, the reality is much more complicated. In reality, economists and finance academics debate to what extent the injection of money into the economy results in that money flowing directly to stocks. Since the bulk of the cash from QE stays at banks in the form of bank reserves, the connection between the two is not so clear cut. Similarly, the difference between 0.25% and 0.5% short-term interest rates is pretty small, yet its impact on stocks is massive.
So what is really going on here? While the movement of cash from the Federal Reserve to the stock market is hard to track, there are three much more provable dynamics that flow from both QE and low interest rates or a ZIRP/near-ZIRP environment.
Margin Loans
The first and simplest is margin lending. Remember that not everyone buys stocks with cash, and most of the largest institutional investors leverage their holdings in one form or another. While your average mutual fund doesn’t use margin loans, a slew of other investors from hedge funds to alternative asset managers will, and the cost of margin loans will go up as interest rates go up. Higher interest rates for margin loans means there’s less room to buy stocks on margin, which means less demand for stocks and thus lower stock prices (or lower stock price growth—an important distinction). This is perhaps the simplest and most deterministic mechanism between higher interest rates and a weak stock market, but it isn’t the most important.
Risk Aversion and the Keynesian Beauty Contest
Active traders, aware that borrowing costs are going to rise and so investors who buy on margin will need to cut back on lending, will begin to sell or short the market to make a short-term profit ahead of that selloff. Other active traders, aware that some active traders will start doing this, begin to sell or short the market to make a profit before them. Then other active traders, aware of those active traders who will start selling before the active traders who are eyeing investors buying on margin that will cut back on lending, will begin to sell or short the market.
Confused yet?
This recursive market behavior was famously coined in John Maynard Keynes’s parable of the beauty contest. Imagine a beauty contest of a variety of very different looking contestants, and you are asked to choose the winner. Since different onlookers have different taste, you will stop trying to assess the beauty of each contestant and start thinking about what contestant the vast majority of people will consider beautiful. Then you might be aware that others will do the same, and anticipate what they will vote for—until you aren’t really voting on who you think is the most beautiful, but who you believe the public perceives to be the most beautiful. It’s no longer a beauty contest, but an accuracy of public perception contest.
This often results in a kind of recursive self fulfillment in markets, something that famous investor George Soros codifies as “reflexivity”. Aggressive and fast investors can get ahead first, but the game can get too abstract and lose touch with reality over time—which is why, eventually, fundamentals do start to matter. Until then, however, investors can bet on future fears of interest rate hikes, creating a self-fulfilling prophecy that can be highly profitable.
Corporate Loans and Earnings Multiples
The third and perhaps most concrete reason higher interest rates affect stock prices is the cost of capital. Higher interest rates mean that debt is more expensive not just for margin lending, but for companies that borrow either by issuing debt or borrowing from banks. As a result of higher borrowing costs, the profit margins they can earn from borrowing and investing in the businesses declines—which will, in theory, lower earnings and should result in lower valuations like P/E ratios and P/EV ratios.
That said, in reality the difference between 25 basis points is pretty marginal, so what matters here is the rate of higher interest rates and the amount. Going from 0.25% to 0.5% interest rates isn’t important when it comes to corporate debt costs; going from 0.25% to 2.5%, however, is. So in this calculation the timing and amount of interest rate hikes will matter significantly, and result in complicated models of new valuations.
DCF Models and the Risk-Free Rate
Speaking of modeling, the fourth reason is a bit more technical and abstract, so its significance is controversial. Nonetheless, the vast majority of Wall Street either uses a DCF valuation model or something akin to it. These models predict stock prices based on their relationship to a risk-free rate, which is almost always connected to the yield of the U.S. Treasury in one form or another. Higher interest rates mean a higher risk-free rate, which means a lower valuation (higher risk-free rates mean risky assets are less attractive relative to the risk-free assets, so their valuation multiple needs to be lower). Conversely, lower interest rates mean a lower risk-free rate, and thus higher multiples.
Since this is largely a theoretical concept, the impact of DCF modeling on valuations often becomes a different kind of Keynesian beauty contest, with different targets battling out for a new equilibrium.
The Fed-Led Recession
The final reason interest rates impact stock valuations is the biggest and most important: the probability of a bad recession.
Recessions are inherently bad, but some are worse than others. The 2008-2009 recession was arguably the worst in history—hence it is often called the Great Recession.
That recession was sparked by asset bubbles due to poor financial regulation; it, like the recession of 1973-1975, saw a much slower recovery and more economic pain across the board for a longer period of time. Like the 2008-2009 recession, the one in the mid-1970s was due to a massive shakeup of the financial system—with several issues (the Fed’s aggressive interest rate hikes, an oil crisis, increased commodity competition—the list really goes on and on) that meant many actors in various markets needed to adapt. That takes time, and thus the effects of the recession were long-lasting.
This resulted in Paul Volcker aggressively raising interest rates in the late 1970s, which sparked another really bad recession that was painful in the short term but, eventually, resulted in a new period of relatively better monetary policy (Volcker is often regarded as a hero in the history of modern American finance for this reason).
However, that and the recession of the 1970s and more recently the Great Recession has taught markets that recessions caused by major shifts in the financial system are much longer lasting and more painful than so-called exogenous recessions caused by a pandemic (2020). Plus, these kinds of recessions can be particularly bad on asset prices—and cause stocks in particular to fall without recovering for a long period of time.
That worry now looms large over markets, with the fear that the Fed will tighten too quickly and cause a recession which, in turn, will cause stock prices to see major collapses like they have in previous periods of rate tightening. And, in the eternal Keynesian beauty contest that is the stock market, traders are eagerly trying to get ahead of that.
That is not a fait accompli by any means, though. Some believe that we will see a soft landing—the Fed’s higher interest rates will cause inflation to slow and the economy to stabilize again at a new level of higher employment without higher inflation. If that happens, stocks will likely surge—and moments of optimism that this will play out are what causes things like the brief bull run we saw before Tuesday’s selloff.
Whatever eventually happens, it is pretty clear that interest rates, in one form or another, rule the roost when it comes to stocks.