Monetary policy by Central Banks, such as the United States Federal Reserve Bank and the European Central Bank, is widely believed to have a significant impact on stock prices. Historically, there is substantial evidence to believe that the stock market reacts to the actions of the Federal Reserve Bank and other global Central Banks. For instance, interest rate changes by Central Banks can impact equity prices through two channels:
- By affecting the rate at which the firm’s cash flows will be capitalized, and
- By altering expectations of future cash flows.
The effect of interest rate on the future cash flow is a result of agents changing their expectations about future inflation in the economy. The United States Federal Reserve Bank actions are important because discount rate and federal funds rate target changes are often viewed by stock market investors as signals of the future direction of interest rates and inflation. Therefore, evidence appear to suggest that changes in the United States Federal Reserve Bank policy influence equity prices.
How The Interest Rate Announcement Affect The Stock Markets
Generally, portfolio allocation rules are often predicated on the United States Federal Reserve Bank monetary policy, therefore most investment advisors depend on the United States Federal Reserve Bank policy as a major input in their portfolio selection process. By examining the reaction of stock prices to announcements of changes in the federal funds rate target, in particular, identifying any asymmetries in the stock price adjustment process around the interest rate change event, we found evidence that stock prices incorporate bad news faster than good news.
That’s investors have a higher aversion to downside risk and therefore react faster to bad news or interest rate rise announcement. For instance, fund managers feel they are penalized more if they underperform in a falling market than in a rising market, therefore are usually to panic and respond faster to the announcement of interest rate rise by the United States Federal Reserve Bank.
For decades, specialists and dealers find it easier and less costly to maintain price continuity in a rising market than in a falling market. Previous studies have established that interest rate changes are negative correlated to stock prices. By examining the impact of monetary policy on stock returns, we can conclude that monetary policy exerts large effects on stock returns.
The Impact Of Announcement On The Stocks
Other studies of short-term stock returns have demonstrated that the announcement of rate changes produce effects, and that the reaction of stock prices to the rate changes is very rapid. By examining the short-term and long-term stock market performance of 16 industries following discount rate changes from 1968-1991, the result indicates that interest rate decreases were followed by significantly greater short-term and long-term stock returns.
The Short-term Impact Of Interest Rate On The Stocks
The short-term results are consistent with the view that discount rate changes signal information about the future course of monetary policy. By using an asymmetric partial adjustment model of stock prices, we can perfectly examine the effect of interest rate changes on stock values. This model enables us to explain the speed of price adjustment and the degree of risk aversion around the interest rate change event.
In efficient markets, publicly available information, such as announcements of changes in the federal funds rate target, affect asset prices only to the extent that such announcements convey new information about either short-run or long-run monetary policy objectives or the likely path of future inflation.
The Effect On Stock Before The Interest Rate Announcement
When analyzing the bihaviour of investors before the announcement of the United States Federal Reserve Bank on the interest rate changes, particularly, monitoring the volatility of stock returns surrounding the announcement, using daily data on the S&P500 stock index from January 1, 1990- December 31, 1998, the period which the United States Federal Reserve Bank is commonly believed to have been targeting the federal funds rate.
The results indicate that target change announcements convey new information to the stock market. In particular, risk aversion appears to increase before the announcement of a rate change, and especially before the announcement of a joint target and discount rate change.
The United States Federal Reserve Bank funds target changes that are accompanied by discount rate changes send a clearer signal to the stock market about monetary policy objectives. We find weak evidence consistent with some form of overreaction in the wake of bad news or interest rate hikes, relative to the announcement of good news or rate cuts.
We also find that volatility has shifted from before to after the target change announcement since 1994, when the United States Federal Reserve Bank began disclosing target changes immediately after making a decision to change rates.
How To Pick Stocks During The Interest Rate Rises
Most importantly, during the interest rate rise, investor must avoid investing in businesses with debt, as these companies will generally see their margins reduced. Instead, investors should invest in stocks with the ability to pass on those higher costs to their customers by increasing their prices.
Also, investors should be able to get some perspective on how strong a company’s pricing power is by researching the company’s annual earnings. If earning volumes remained strong, then it’s a good sign that the company has at least some measure of pricing power.
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