Interest Rate hike and stock market: What should you do after rate hike?

Stock market in the US and India fell after the Federal Reserve in the US increased interest rates by 0.75% to fight soaring inflation. The U.S. central bank lifted its benchmark policy rate for the 5th time in the year, bringing the federal funds rate to a new range of 3.0% to 3.25% — its highest level since 2008 — from a current range between 2.25% and 2.5%. 

Nifty versus Nasdaq: How has the rate hike impacted India and the US?

Nifty 50 in 2022

Nasdaq in 2022

How has the Nasdaq and Nifty behaved in previous instances of rate hike?

Here’s how the US market has behaved in the previous rate hikes: 

Yesterday, after the Fed announced a 75 basis point rate hike, the NASDAQ closed 1.8% lower. Even the Indian equity market opened with a gap down and closed 0.50% lower. Does it mean the US Fed's interest rate hike impacts the Indian market directly? Let us look at previous instances to draw a conclusion.

• On 27 July, the Fed increased the interest rate by 75 bps. However, at that time, the US market cheered the decision as NASDAQ soared more than 4%. Even the Indian equity market opened with a gap-up and closed nearly 1% higher post the announcement.
• On 15 June also, the Fed hiked interest rates by 75 basis points, and the market reacted positively, as NASDAQ closed 2.5% higher. However, on 16 June, NIFTY cracked 331.55 points or nearly 2%.
• On 5 May, the NASDAQ closed 3.2% higher after the Fed announced its May FOMC policy decisions (50 bps hike) that were in line with the market’s expectations. NIFTY50 fell more than 1.5% the following day.

Market reaction is largely governed by two factors:

• Was the rate hike in line with market expectations?
• What is the Fed's stance and future targets?

The answers to these questions can help investors know the market's direction in the short term.

Nasdaq vs Nifty: Period-to-Period performance

• As seen from the chart above, the Nifty has remained largely resilient in the year so far despite huge interest rate hikes. However, rate hikes fears do hurt sentiments in the short-term, as it could lead to outflows from emerging markets such as India, thereby impacting the Index returns.  

Interest rate hike - Why is it done?

The first thing investors need to know is why the Fed is continuously increasing the interest rate. Also, why does it plan to continue doing the same?

After the pandemic, to ensure the economy did not collapse, the Federal Reserve made sure that the people of the US had excessive cash so spending would not stop. They pursued a policy that they termed as 'easy money'. It meant that fed interest rates were kept at low levels. With high liquidity and lower fund rates, investors moved to the equity market, and hence we saw a jump in stock prices post March 2020 crash.

However, there was a negative impact of the 'easy money' policy. It led to higher inflation, and now the inflation numbers are out of control for the US government and the Fed. 

To bring inflation back within its target limit (2% to 4%), the Fed is increasing the interest rate. With higher interest rates, borrowing becomes expensive for both businesses and individuals, and people spend less on housing, loans, etc. With this, inflation comes down (demand comes down).

Increased interest rates and the stock market

In an ideal scenario, an interest rate hike should adversely impact the equity market (US stock market). It is expected that economic growth will slow as the Fed tightens interest rates.It also affects the future earnings growth of companies. We have already seen the impact on the US economy of continuous rate hikes - the GDP growth has slowed in the first half of 2022 (since the rate hike started). 

Another reason for the stock market's impact is that, with changes in interest rates, bonds and certificates of deposit become more attractive for investors as they have a higher yield. Most investors move out of the riskier equity markets and invest their money in bonds - the future earnings look less attractive versus bonds that pay more competitive yields today.

Fed rate hike 2022: Outlook going forward

The US Fed has raised its target interest rate by three-quarters of a percentage point to a range of 3% to 3.25% and signaled more large increases to come in new projections showing its policy rate rising to 4.40% by the year-end. In 2023, the policy rate hike is expected to top out at 4.60%. With this, inflation is expected to return to the Fed's 2% target in 2025.

• After yesterday’s fall, the S&P has dropped more than 10% in the past month and is off 21% off its 52-week high.
• Analysts now expect the US Fed to continue to increase interest rates further to tame higher inflation. However, the concern is that this could lead to an economic slowdown.
• The markets expect the rates to settle around 4% from 3.2- 3.25% range currently. Billionaire investor Ray Dalio has recently warned of a meltdown of 20% in equities if rates rise to around 4.5%.

What’s happening to the US Dollar?

• Due to the aggressive interest rate hikes, the dollar index has jumped more than 16% in the year so far. 
• The relentless rise in the dollar has meant a huge depreciation in the Indian Rupee. 
• The Indian rupee dropped to a record low of 80.86 against the US Dollar, due to  concerns over the pace and quantum of U.S. Central Bank’s policy tightening ahead.
• The major concern is that a stronger dollar would prompt outflows from emerging markets such as India, leading to a decline in the Nifty 50 index. 

While the domestic economy remains resilient, negative global cues could lead to a selloff. A higher interest rate could lead to outflows from emerging markets such as India, leading to further declines in the market. 

What should you do now?

• The markets are expected to remain volatile in the near future. It would be a good idea to build a war chest so that you can re-enter at better levels. 
• Invest in equities in a staggered manner. Avoid lump sum investments.
• Keep your SIP’s running. Stick to large caps and index stocks that are best suited to navigate the ongoing volatility. Explore mutual funds SIPs.
• Avoid buying high debt companies and look out for companies with higher pricing power that can pass on the inflation to customers with strong balance sheets.
• Having a proper equity, debt allocation on the basis of your risk profile and goals is the key.
• Ride out the volatility by starting SIPs in US Stocks. Explore US stock SIPs.