Fight the Fed

FOMC meetings are some of the most closely watched market events. Through the years, interpreting Fed-speak has become a true art form amongst analysts. Once upon a time, market participants looked to see what the Fed was doing with short interest rates and that was about it. Nowadays, every single word of the Fed Chair's statement is scrutinized.

Many believe you can game the markets by interpreting the "tone" and "syntax" of Bernanke's words. "Oh dear! Bernanke changed the word ‘was' to ‘is', or ‘big' to ‘large'." (We're not kidding…people actually make investment decisions based on this stuff.)

Yesterday, the Fed left rates unchanged at 5.25%. This was not a surprise. Stock markets are forward-looking mechanisms, so once we know rates are unchanged for now, the news gets priced in and the markets start thinking about the next meeting.

Looking forward, many believe that the stock market's performance is predicated on what the Fed, or any major central bank for that matter, will do. The prevailing wisdom is: cutting rates will provide more liquidity and a propensity to lend, therefore stimulating the economy. Raising rates, by contrast, chokes off liquidity and economic activity suffocates along with it.

And you've probably heard all the old sayings that go along with Fed analysis. "Don't fight the Fed" is the most common one.

In short, it's commonly believed the movement of short rates has the power to move stocks. But is it true?

Consider:

• Throughout the Bull market in the mid to late 90s rates were increasing.
• Through most of the bear market starting in 2000 and lasting into 2002 short rates were slashed down to 1%.
• Then the bull market began in 2003…when the Fed began its cycle of rate hikes all the way back up to 5.25%.
• Now the Fed has held steady at that rate for over half a year…and stocks have been up.

And we can make similar points in the UK and the European Union. Even more interesting, Japan had essentially zero interest rates for years, and also a sluggish stock market. Only when the Bank of Japan decided to end its policy of Quantitative Easing and even explored raising rates did Japanese stocks surge.

The point is not to say short rates move stocks in different ways than people commonly believe...the point is that short rates don't necessarily move stocks at all!