US Stock Market & Fed Funds Rate

The Federal Reserve controls an interest rate called the Fed Funds Rate. What does it mean for the US Stock Market when the rate goes up or down?

An objective of the Fed is to control the growth rate of the economy, aka the rate of inflation. Typically this inflation rate is about 3% per year. Having inflation significantly above or below this rate is bad for the long term health of the economy. Deflation, something that we are seeing now, is viewed as especially bad for the US stock market.

When the Fed increases this rate it means that economy is growing faster than the 3% target. Conversely, when the Fed decreases this rate it means that the economy is not growing as fast as the 3% target.

The US stock market grows as the economy grows. A direct link exists between the performance of the economy and the stock market. From a macroeconomic perspective, a growing economy would result in growth for the publicly traded companies. This means that as the Fed funds rate is increasing the stock market should do well. Conversely, as the Fed funds rate is decreasing the stock market should do poorly.

The Fed funds rate is essentially an indicator of the direction of the stock market. It is important to watch the Fed funds rate, especially when it gets above the target 3% rate.

In 2000 and 2007 when the Fed funds rate were well above 3% the stock market was doing well. When the Fed lowered the rate, indicating a slowdown in the economy, it would have been wise to have moved most of the money from the stock market and put it in bonds. Also, an inverted bond yield curve condition existed in both time periods.

Did I move my money stocks to bonds in 2000 and 2007? No, I did not and it cost me lots of money. Will I make this same mistake again? Never again, I will not make this mistake a 3rd time.

Why didn't I make the move? Partially, it was due to listening to the experts who have jobs to write articles to make money for publications. Partially, it was due to a bad model that I was taught that showed the stock value increase as the interest rates decrease.

The higher the deviation from the Fed funds rate the larger the move with the rate changes. When the Fed begins to raise this rate, which will occur in the future, this is a very positive indicator for the stock market.

The bottom line: Do not listen the experts and watch for changes in the Fed funds rate. As it is going up be heavier in stocks for your long term investments and as it is going down be heavier in bonds for your long term investments.