Wide-Spanning Market Implications When Fed Changes Its Tone

Recently, when Federal Reserve Chair Janet Yellen went up to Capitol Hill for her semi-annual monetary policy testimony, the market was caught unawares. Traders have begun to discount an environment, where the fed funds rate would continue to rise steadily and by small increments, and the incoming pieces of economic evidence were also supportive of this stance.

However, when Yellen sounded dovish, all trading bets placed on the assumption that rates will rise began to unravel.

Dove Vs. Hawk

Dovish language suggests an intention to have an extremely accommodative monetary policy environment characterized by low interest rate in order to stimulate growth.

On the other hand, a hawkish tone would mean maintaining a tighter monetary policy environment, where interest rates would be high. This is done in order to combat rising inflationary pressure and happens especially when the Fed is convinced of the stability of the economic recovery.

The change in the tone, even the nuances, could lead to a paradigm shift in the way investors plan and make their investment moves.

Broader Market And Fed Lingo

For the overall market, a change in tone, especially a bearish disposition would generate negative sentiment, given the mindset that higher interest rates are bad for the economy, which essentially is not always true.

On the contrary, an indication that rates may go low or will be maintained low would trigger a positive reaction, instilling confidence in economic growth.

On July 12, when Yellen testified before the House Financial Services Committee, she said the neutral rate is "quite low" by historical standards and that the rate doesn't have far to go to hit a neutral stance for policy.

The message that the interest rates, even if hiked, may not go to the levels that could begin to pinch created a frenzy in the market. The S&P 500 gained 0.73 percent on the day and tacked on another 0.20 percent in reaction to the second day of Yellen's testimony on July 13, helping the index to inch close to a new record.

Sector-Specific Implications

Unlike the general perception of a salubrious impact of easy monetary policy, there are sectors that would benefit when interest rates are high as well.

Below are the sectors that stand to benefit from a rising rate environment:

Financials:

Most financial companies, especially the ones which have banking operations as their core business, derive a major proportion of their revenues from the spread between the interest they pay for deposits and the interest they charge on loans, which is known as the net interest income.

Fed funds rate is the rate at which depository institutions lend their reserve balances to other such institutions overnight, on an uncollateralized basis, just so that the latter meets its reserve requirement.

Banks are mandated to hold a small proportion of their total deposits as reserves internally, or deposited with the Federal Reserve, and this is called the minimum reserve requirement. Reserve balance would mean what is held in excess over the minimum reserve requirement.

Since the Fed funds rate is the benchmark based on which all the other interest rates are set, it impacts mortgage rates, bank lending rates, both for consumers and businesses.

Other sub-sectors of financials, namely stock brokers and insurance companies also do well when interest rates rise.

Consumer Discretionary Stocks:

A rising rate environment is synonymous with the economy turning a new leaf and reaching some semblance of stability. In such a situation, people will become less circumspect and splurge on consumer discretionary items, which are non-essentials.

Tech Stocks:

A better economy would mean higher tech spending by consumers and businesses, and therefore, increased business prospects for tech companies.

Sectors Benefiting From Low Interest Rate Environment:

• Debt-heavy firms such as telecom, REITs and utilities, which may be forced to pay through their nose to meet interest commitments on their piling debt.
• Dividend stocks may lose their appeal, as investors have now other avenues that fetch them better returns than investing in stocks.

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___________ Image Credit: By Federalreserve - BKLM4457, Public Domain, via Wikimedia Commons