Why the Fed Impacts Markets

When it comes to the Federal Reserve, there are three important factors at play—but you’ve probably only heard about two of them.

First, let’s back up. The Federal Reserve is important because it controls the money supply and it targets short term interest rates (which, for the most part, then influence long term rates). Unlike some other central banks, which control both short and long-term rates, the Fed is specifically in control of its Federal funds rate target, which it reaches through open market operations (simply buying and selling U.S. government debt to keep it at around that rate). 

These rates have tremendous implications for the world economy. For our purposes, let’s limit to securities market responses. Bonds will go down in value (and yields will go up) because newly issued bonds at the new rate targets will yield more than the old issued bonds, making them less valuable.

Similarly, stocks tend to go down as rates go up, but the relationship is less mechanical than with bonds. For several reasons, market expectations for equity returns fall as rates rise, so stocks go down.

Now here’s the kicker: the Fed’s interest rate policy changes over time. The easiest way to see this is by comparing dot plots.

Here we see the FOMC (the Fed’s board for setting target interest rates) projecting 3.25% in 2022 and 3.75% in 2023. These were the expectations back in June.

In September, they looked like this:

Here we see that the majority view is now for 4.25% for 2022 and 4.75% on average for 2023—so the Fed now sees rate hikes going higher and deeper into next year.

Obviously, the  conclusion is that bonds and stocks will fall in light of these new expectations—and so both markets fell significantly after September 21st, when this dot plot was released.

Why the Fed’s changing view? Remember the Fed’s dual mandate is to control inflation and unemployment, ensuring neither gets too large. The former is too great now, so the Fed is aggressively hiking rates to respond—and the fear is that this will result in higher unemployment and a recession, which will cause the Fed to cut rates in the future.

These two dynamics—market conditions and the Fed’s response—are perhaps the most common topics for chatter among the financial press in 2022 (and, to be honest, they’re some of the most common topics pretty much all the time). But there’s a third thing that is crucial in the equation: market expectations.

First, let’s explain why this is important. The market doesn’t always crash when the Fed raises rates. For instance, the S&P 500 (SPY) went up over 5% after the hike in July.

Why does the market go up sometimes when the Fed hikes rates and goes down at other times? It all boils down to market expectations.

For the most part, if the Fed hikes rates lower than expected, that’s bullish because of the bearish impact of higher interest rates stated above—if those are priced in and the Fed is less hawkish than markets expect, the market will surge. Similarly, an overly aggressive rate hike (or a speech that suggests more aggressive rate hikes in the future), and markets will fall. This happened in September but did not in July.

To know how the market is likely to respond to a FOMC meeting, we need to know not just market conditions and the Fed’s response, but also market expectations of that response—securities markets are recursive, reflexive things that respond not just to exogenous new information (like the Fed) but endogenous expectations of new information (like the market’s expectations for the Fed).

Knowing the market’s expectations is easy; one simply has to calculate the price of Fed Fund futures contracts that trade on the CME’s exchange, as these reflect what the market thinks is the economic value of those futures contracts vis-a-vis the Fed Funds rate itself.

That data isn’t easily accessible or easy to calculate, but the CME has you covered with the CME FedWatch Tool.

This has been used more aggressively in 2022 on Wall Street than it’s been used in years, but it has a long pedigree and has been a helpful tool for strategists for a long time. By simply choosing a date, we can see the percentage possibility that rates will go to that level on that date.

For instance, the market now sees two rate hikes (75 and 50 bps, respectively) in November and December, ending the year at 425-450 basis points for a target range. This is very different than expectations were a few days ago.