The Fed And The Stock Market: Learn Why It Matters

The Federal Reserve ("The Fed") of the United States is a main, if not the most important driver to changes in stock prices. They have several tools that are used to move stock prices. The Fed knows that a change in the stock market changes investor and consumer psychology which can then affect changes in the economy.

The Fed also knows that their interest rate changes have a direct affect on buying, investing and business decisions which in turn also affect the stock market.

Moves, changes, hints and potential changes by The Fed are a key driver to stock prices. Without paying attention to the Fed, what they are currently doing and what they are likely going to do, it's like driving a car with one eye and maybe two eyes closed.

I believe after reading this you'll be better informed to add thinking about the Fed into your investing process.

Let's review what the Fed does, how it works and why that's incredibly important to know for traders and investors.

Let's discuss briefly what is The Fed.

The Fed was created by the US government back in 1913. The Fed was designed to balance the market and the economy and was granted immense power by the government to do so.

More recently The Fed received it's 'dual mandate' from Congress in 1977 to maintain stable prices and maximum employment.

First, let's discuss the main Fed tools and then we'll discuss why they are so important to the stock market. Then we will review how to follow them so you can hopefully make better and more informed decisions about the timing and sizing of your trading and investing.

How Does The Fed Funds Rate Affect The Stock Market

The Fed over the history has primarily used its Fed Funds rate to adjust short-term rates and allow banks and financial entities to borrow and lend from The Fed at these prevailing rates. Then these banks and entities borrow to and lend from the public and private sectors, people and businesses.

When the economy is too weak or overheating the Fed will change that short-term rate making it easier or harder to borrow.

By lowering rates, The Fed acts to incentivize consumers to spend and businesses to invest. When the Fed lowers rates, banks, in turn, offer lower yields on their money. It's not then worth it as much to keep money in the bank at lower rates. That juices the economy by getting money to flow from deposits and instead cycle into the economy from buyers to sellers and from lenders to borrowers.

At lower rates, businesses have lower interest expense making their break-even on new investments and new inventory purchases lower so it will be worth it for them to invest more.

At higher interest rates, those rates compete for spending and investing dollars.

If someone is getting a good return in their bank by leaving their money there it's a harder decision to pull the money from the bank to spend or invest it.

The same holds for companies or investors.

For companies if they have a higher interest rate in the bank it may cost more to fund inventory investments and other investments in the business. Their return-on-investment hurdle is raised making cash reallocation decisions tougher. The money more easily remains in the bank at higher rates rather than swishing around pushing the economy, helping the economy.

You know yourself if you are a consumer, a business or a lender, changes in short-term rates which are mainly driven by The Fed's Fed Funds Rate affect your decisions. That same thought process affects many and so affects the economy as a whole.

Let's go to the next step to understand how that effects the economy.

If the economy is booming and inflation is booming, because they usually go together, if left unchecked, inflation can end up making it harder for consumers to make purchases down the road. It can make economic cycles have sharp ups and downs.

Sharp ups and downs in the economy ruin long-term consumer and investment confidence and so the longer-term potential of the economy.

If the Fed can manage the prevailing interest rates rather than letting general market sentiment, fear, greed and emotion drive rates, that can conceptually smooth out economic cycles. That's the thinking anyway.

So when growth and inflation heat up too much the Fed will raise their Fed Funds rate to offset some of the bubbling up of the economy.

It works the same the other way.

If the economy crashes and prices drop to deflation, that can also tear away at the longer term confidence of consumers, businesses and investors.

So to smooth down cycles out the Fed will generally lower the Fed Funds Rate to make it easier for entities to spend, borrow and lend. That is meant to smooth out the economic cycles.

So you can see generally that actions by the Fed on the Fed Funds Rate can directly affect the economy.

The economic direction and/or change of direction or slope can also affect the stock market as stock market players get more or less confident in the future potential of market and stock earnings based on the current economic trajectory.

So based on these same moves, lower or lowering interest rates should generally help the stock market and higher or raising interest rates should generally hurt the stock market.

How Does The Fed Affect Psychology Which Then Affects The Stock Market?

While some of these interest rate changes driven by the Fed Funds Rate may take time to seep into the system, the Fed also knows that their commentary and moves can affect the stock market moves which can then in turn help their goal to smooth out or juice the economy sooner.

The Fed's tools are designed probably most importantly to move the stock market because the stock market is a prevalent mechanism that drives consumer, investor and business psychology. When the market is down consumers can get concerned and so want to buy fewer goods. When business leaders watch a down market they may hold back on new initiatives or may avoid adding to inventory purchases. Economic participants like consumers, lenders and business leaders have come to learn that general, medium-term movements in the stock market affect psychology of their counterparts. Thus stock market moves affect psychology which can cycle into trends.

Since the Fed has powerful tools to affect the stock market, the stock market can affect economic players' psychology.

So instead of the common thinking that the Fed effects the economy and so that affects the stock market, in reality first the Fed affects the stock market which can then have a psychological influence on the economy.

The Fed knows that the tools themselves and their Fed-speak about their actions affects the economy but also, more importantly directly affects the stock market which can cycle back to doubly affect the economy.

How Does The Fed Balance Sheet Affect The Stock Market?

We discussed above how the Fed affects short-term interest rates with their Fed Funds Rate.

Let's now discuss how the Fed affects longer-term interest rates with their balance sheet and how that can affect the stock market.

The Fed has been allowed to buy government securities. To buy those securities they need to increase the size of their balance sheet. Buying securities can coincide with the need to print more money. The printing of more money increases the supply of dollars in the market which can affect the price of the dollar itself versus goods and other currencies.

When the Fed buys US Government bonds they thus increase the supply of money into the system. They act as a buyer from the government giving them money to spend on government projects which filters into the economy.

When buying government securities and thus increasing the supply of money that can lower the value of the money itself. Understanding the laws of supply and demand, the more supply of something, in this case money, can reduce the value of the money itself. The value of money itself is defined by its ability to exchange for goods or other currencies.

So simply, the more money they print to buy more government bonds, the more supply of money they create. That increased supply of money reduces the value of the money itself reducing the money's relative value. The cost of goods to purchase with that money would go up in relative terms because the money's intrinsic value goes down as its supply moves up.

That can cause inflation by lowering the value of money itself but it can also stimulate to the economy. in several ways.

Since it appears that The Fed can buy pretty much as much as it wants of US securities that affects the price of those securities (bonds, notes, etc) and so inversely affects the yields of those bonds.

The more the Fed buys it creates a huge demand push raising the prices of those bonds. That makes bonds more expensive but also pushes that bonds interest rate yield lower.

The Fed in this way affects the longer-term interest rates of the market and the economy.

When the Fed has desired to reduce its holdings it lets government securities mature. It's lack of purchases reduces overall demand for securities which can lower the demand and so the prices of the government securities themselves. That inversely raises medium and longer-term yields which affects the economy and the stock market.

The Fed Funds rate affects shorter term consumer, financial and business decisions as explained above.

But the balance sheet affects longer-term yields which can directly impact stock values and stock market price levels when understanding the discounted cash flow model.

Don't worry, I'm going to keep this very simple. Don't get concerned. So go with me slowly here and you can always read it a couple of times. It's important and worth it to understand how stocks and the Fed work.

Source

The above formula, DCF or Discounted Cash Flow model is a formula to understand the current value of all potential future cash flows of an entity. There is of course no perfect model to predict the future but if you could, you could know what should be the exact value of that related security. Wouldn't that be nice?

So you can't know the exact future cash flows of a company, right? But that's ok. Because you can know the "r" part of the formula which I will explain. That "r" part of the formula directly affects stock prices which I will also explain.

If you can know all the future cash flows of a company, you can then work backwards to figure out what that company should be valued at and so what its stock price should be valued at based on using the DCF formula.

To keep it simple, consider the DCF formula as an important concept of market pricing rather than planning to use it to try to find precise valuations.

So instead of trying to guess or worry about what will be the future cash flows of the company let's just agree there will be a specific level of cash flows and earnings of a specific company, ok? Whatever those future earnings in those future earnings periods will be, let's just call them "Cash Flows." That's the CF in the formula above. CF1 is the nearby period and it goes further out.

Again, of course nobody exactly knows what those CFs will be in the future. We do try to figure out the next year or so earnings based on recent trends of a company but the DCF and CF is more conceptual for contemplation at this point to understand how yields, interest rates and so the Fed directly affects stock market moves.

So for our understanding we're going to agree to keep those future CF numbers constant, whatever they are going to be. Keeping those constant in your mind is important for this exercise because it's going to help you to focus and understand how interest rates by themselves affect stock prices.

So even though we don't know the future cash flows (CF) we're agreeing they are what they are going to be and we're going to keep that constant in our head, ok?

The further away your cash flow is, the less it's worth, right? The sooner your cash flow is the more it's worth. Is it worth it more to you that I give you $1000 today or that I give you $1000 in 10 years? It's worth more that I give you $1000 today because you can invest it and it potentially be worth more in the future. Who knows what's going to be 10 years from now.

The DCF formula above relates to that in the denominator (the lower part below the flat line) of the equation above.

And since it's the denominator, by mathematical definition it has an inverse relationship to a numerator (the top part of the formula) or the resulting DCF or current stock value of the formula. It's that current stock price value understanding that we care about. That's the DCF on the left side of that formula.

The DCF is, I think, the simplest concept to understand how stock prices and the stock market gets valued. By understanding the concept of this formula you understand in basic terms how the stock market prices and values and so changes in value which is pretty important, right?

And so if the denominator goes down in an equation, inversely the DCF value or the current stock price value would go up. If the denominator goes up, inversely the DCF or the current stock price value goes down. It's inverse, ok?

So we may not know the numerator CFs but we can know the "r" in the denominator which is directly related to the prevailing level of interest rates.

So as "r" or the interest rate goes up all those future cash flows are worth less today than they were (remember we're keeping the CF constant). As the future cash flow values go down then the current (present value) DCF value goes down, down goes the stock prices.

As the "r" of that DCF formula goes down, all those future cash flows are worth more, all other things equal. Thus if future cash flows are worth more the present value of those future cash flows, or the stock price is worth more.

You can scroll up and review that a few more times until it sinks in but, to me, that is the easiest way to understand how stock prices work and how both earnings (related to CF) and interest rates affect stock prices.

So now let's get back to The Fed. As they buy or let mature those longer-term government securities with The Fed's, yes, trillions of dollars in buying power, they move bond prices and so inversely move longer-term interest rates and yields.

Those changes in yield change the "r" in that formula inversely affecting the present value of those future cash flows thus affecting the current price.

Here you see in concept how the Fed's decisions with its Balance Sheet can directly affect stock prices.

As the Fed moves longer-term rates up and down, they directly affect the DCF inversely which directly affects the main elegant pricing mechanism of the stock market world, the DCF.

To me, the DCF is the simplest way to understand what drives stock prices; earnings (CF) and interest rates ("r").

Thus you can see how the Fed can directly affect stock prices through their Balance Sheet moves.

The Fed Itself Drives Economic Cycles

Printing too much or too little money, being too aggressive in raising or lowering interest rates can itself cause economic cycles.

The Fed is run by human beings. Those human beings are imperfect as can be understood. Being human they have many forces driving them. Of course they want to do a good job and achieve their goals and mandates but they can also get caught up in emotion, group think, their own intellectual models or get concerned that hurting the economy actually will hurt many people's daily living.

Since the Fed is made up of humans and it's well accepted that humans are not yet perfect and they make mistakes, so too the humans running the Fed can make mistakes and they often do.

The Fed's moves and mistakes can directly drive economic and stock market cycles.

Since the Fed carries with it such incredible importance to short-term and long-term interest rates, their moves matter.

It should be understood how their moves affect inflation and the economy and so if you find them leaning the wrong way, that can also affect the economy.

Often the Fed can misread data and move in a wrong direction which will mean they'll have to double back the other way. That doubling-back the other way is probably a more important driver to the market because the Fed acts usually faster and sharper when in that mode.

It's important to understand how the Fed is affecting markets but it's also important to understand if they are maybe doing too much or too little and how that can affect their future decisions.

Since, markets are a discounting mechanism of the future to determine current prices, changes that can be expected in the future also affect current prices. We saw that in the DCF formula above.

So even if the Fed is in a mode of raising or lowering interest rates, if that is the wrong move and they'll need to reverse, that can affect future discounted cash flows based on changing the denominator as we discussed above.

I believe that the main driver to stock prices are moves within one year into the future. So if you can catch trends that the Fed is right or wrong then you can guestimate if the "r" interest rate is going to continue or reverse in the future. And if that change is going to be within one year, I think that's important to markets and can already start getting factored in by large, smart, financial institutions that also affect stock market pricing.

How To Follow The Fed To Trade And Invest Better

There is an old adage 'don't fight the Fed.' That means when they are lowering rates or keeping them low, don't think too much, it's usually good for markets. That said, there is a lot of data and history and you can look at the charts to see how past moves have affected the stock market.

When they are raising interest rates whether through the Fed Funds Rate or the Balance sheet it can be a headwind for stock market performance. When they are lowering rates it can be a tailwind.

It's important to understand which direction the Fed is moving and what are the key indicators that they track so you can also have an opinion on where they might move next; keep the path or change.

Their mandate is to keep jobs strong and keep inflation in check. So the two main economic data that they care about are jobs and inflation.

Of course there are many things that drive the stock market and Fed decisions but the main things that drive the Fed decisions are changes in jobs and inflation. There are many data sets out there that can imply how key jobs and inflation data will fluctuate.

I think it's important to understand the Fed's position on current data but I also think it's important to have your own simple understanding of the trend of that data and how that trend may affect future Fed decisions. Because, remember, future rate changes do affect stock prices directly and indirectly. And since the Fed is human and the future is not perfectly predictable, the Fed can also change in the near future.

Putting It All Together

You can now understand how the Fed by affecting short and long-term interest rates can affect the economy and stock market directly. You can also understand how the stock market can affect the economy and the economy can affect the stock market. Thus the Fed that directly impacts both the economy and the stock market has a duplicative affect on both that cycles back and forth.

Following the Fed and what makes the Fed tick, I believe is key to understanding moves and changes in the stock market, stocks, bonds, cryptocurrencies like Bitcoin and more.

Hope you enjoyed.

Wishing you success.

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