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What does a rising Fed Funds Rate mean for US equities?

Equities 5 minutes to read
Peter Garnry

Head of Equity Strategy

Summary:  The FOMC has set the trajectory for seven rate hikes and a terminal rate that is above the estimated neutral rate which suggests that the Fed has acknowledged that inflation is more sustained than initially thought and that it will not go away unless demand is dampened by tightening financial conditions considerably. This is because the world economy is severely supply side constrained and it takes time through investments to expand supply and the global supply chain could also remain disrupted for longer due to the war in Ukraine and new lockdowns in China. Finally, we take a look at historical US equity returns during periods of rising and falling effective Fed Funds Rate.

A hawkish FOMC was not enough to pull US equities down

The FOMC decided yesterday to hike the Fed Funds Rate for the first time since the pandemic started and the overall message was in line with previous statements striking a hawkish tone. The dot-plot rose to suggest seven rate hikes this year and a terminal rate of 2.75% which is above the neutral rate currently estimated at 2.38%. Chair Powell and the Fed have now acknowledge the seriousness of inflation and guiding the terminal rate above neutral suggest that the Fed is keen to dampen demand through tighter financial conditions. This is recognizing that the supply side of the economy will not expand fast enough to get inflation under control in a meaningful time period and thus demand has to be dampened. The FOMC also announced that balance sheet reductions will start in May from previously June. The two key risks to the outlook are the war in Ukraine (and sanctions on Russia creating turmoil in commodities) and the lockdowns in China causing disruptions in global supply chains.

The US equity market responded positively to the FOMC decision and subsequent communication with the S&P 500 futures gaining 2.3%. The positive sentiment was also helped by China’s message to support the economy and its equity market in addition to more positive tunes coming out of the peace negotiations between Russia and Ukraine. However, in today’s session some of the gains are given up due to higher commodity prices and most notably a higher oil price. But what does a higher Fed Funds Rate mean for US equities?

US equity returns are strong during rising Fed Funds Rate

Using data on US equity returns, US Treasury returns, and the effective Fed Funds Rate (FFR) we can get an idea of the historical relationship. In this period we have 589 monthly observations with around 300 being an unchanged or negative month in terms change in the effective FFR while we have 289 observation in which the effective FFR rises. The average monthly US equity return is 1.43% during months when the effective FFR is up and 0.29% when the effective FFR is down; the difference in means have a t-statistic value of 3.15 or p-value of 0.0017. Subtracting the risk-free return (return on US Treasuries) we get an excess monthly return of 0.77% when the effective FFR is rising and -0.16% during months when the effective FFR is declining; the difference in means have a t-statistic value of 2.47 or p-value of 0.014. In other words, US equities deliver a significantly higher return and excess return over US Treasuries during periods of rising effective FFR. If history repeats itself this bodes well for equity returns, but one caveat is that equity valuations remain above their historical average adding headwinds if they continue to mean-revert on the outlook for inflation and prolonged war in Ukraine.

Source: Saxo Group

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