Short-term Outlook:  25% Bearish  From Feb 17, 1097 SPX

Equity Indicators - Updates and Extremes

The Federal Reserve's Rate Decision On Markets

In the absence of any new extremes among our indicators, we might as well touch on the topic du jour, which we're all going to be tired of reading about by day's end.

In case you hadn't heard (haha!), the Federal Reserve raised the Discount Rate it charges to banks by 25 basis points.  This was telegraphed by Mr. Bernanke last week, which was nice of him, but as usual they decided to wait until an inopportune time to implement their policy (futures markets were closed and it was the day before option expiration, trapping traders in index options).  I still don't get why they keep doing that.

Let's go back to 1932 and look at every time the Fed raised the Discount Rate after a period of easing.  I took some liberty with "easing", not including any instance, such as in the 1960's, when there was just one cut in rates before another hike.  I also excluded 2003 when they shifted the way they report the rate.

The table below shows the forward returns in the S&P 500 following each of the initial hikes in the Discount Rate.

There really isn't much consistency in the numbers, which will disappoint those who assume that a hike in rates is an automatic sell signal.  That worked a couple of times, including the last two instances, but historically it was inconsistent.  In fact, a few days later, the S&P was higher three quarters of the time, but that dropped back after a couple of weeks.

 

S&P 500 Performance After Initial Hike In Discount Rate After An Easing Cycle
Date	Rate	1 Day Later	3 Days Later	1 Week Later	2 Weeks Later	1 Month Later	3 Months Later	6 Months Later	1 Year Later
04/25/46	1.00	0.2%	1.0%	0.9%	-0.2%	0.5%	-3.0%	-17.8%	-18.7%
04/15/55	1.75	0.8%	0.8%	0.1%	0.0%	-2.5%	11.7%	9.0%	26.3%
09/12/58	2.00	0.9%	1.7%	1.8%	2.3%	6.4%	9.7%	16.5%	17.4%
07/17/63	3.50	-0.6%	-1.5%	-0.9%	0.3%	3.6%	5.0%	11.1%	21.9%
07/16/71	5.00	-0.2%	0.2%	-0.2%	-3.6%	-0.4%	-1.0%	3.9%	7.2%
01/15/73	5.00	-0.3%	0.3%	-0.2%	-2.2%	-2.8%	-5.9%	-10.7%	-20.4%
08/30/77	5.75	0.4%	1.1%	1.7%	0.2%	-0.5%	-1.9%	-9.5%	7.3%
09/26/80	11.00	-2.2%	0.6%	2.4%	3.1%	1.2%	6.9%	6.3%	-8.6%
04/09/84	9.00	0.3%	1.5%	1.8%	1.7%	3.0%	-1.6%	4.3%	14.6%
09/04/87	6.00	-1.0%	0.1%	2.0%	-1.9%	0.8%	-29.3%	-15.6%	-16.5%
05/17/94	3.50	1.0%	1.2%	1.2%	1.8%	2.8%	3.5%	3.7%	17.5%
08/24/99	4.75	1.3%	-1.1%	-3.2%	-1.4%	-6.1%	4.2%	-0.2%	9.9%
06/30/04	2.25	-1.0%	-2.2%	-2.8%	-3.0%	-3.4%	-2.3%	6.4%	5.2%
Average		0.0%	0.3%	0.4%	-0.2%	0.2%	-0.3%	0.6%	4.9%
% Positive		54%	77%	62%	46%	54%	46%	62%	69%
Any random time...
Average		0.0%	0.0%	0.1%	0.3%	0.5%	1.5%	3.1%	6.6%
% Positive		53%	54%	55%	56%	58%	61%	64%	66%

Stocks have never traded in a vacuum, but now more than ever, asset classes are highly correlated.  So let's get away from stocks and look at some other markets and their relationships to the Discount Rate.

There was mostly inconsistent behavior going forward.  The most consistent among them was the Yield Curve (the spread between 3-month and 10-year Treasuries), which showed a decline after six months every time but once, averaging 40 basis points.  That seems likely to happen once again, given how steep the curve has been recently.

If I was forced to suggest a general pattern, I would say we typically saw higher short-term rates (which makes sense), lower long-term rates (which flattens the yield curve), a lower Dollar (which doesn't make as much sense) and higher commodities.  Again, however, there was considerable variability among the precedents.

The Fed also suggested that this hike in the Discount Rate does not necessarily mean they are going to lift the Federal Funds rate, which would be a more pronounced policy shift and have more impact on everyday interest rates.

If so, that would be a historical change, as the chart below shows.

Typically, the Fed hoisted the Fed Funds rate up right along with the Discount Rate, or even a little ahead of time.  While this is certainly a most unique period of history we're living through now, it would be unprecedented to not see a corresponding increase in the Fed Funds rate.