What the Fed’s rate cut decisions mean for various asset classes

The dollar sees strength and weakness in proportion to the federal funds rate.

The US Federal Reserve has held interest rates steady but indicated it will slash rates three times later this year. Fed chairman Jerome Powell's March 20 policy announcement sent the markets surging and gold to a new high but bond yields ticked down. Why did this happen?

Through this explainer, let’s break down what the US central bank's actions mean for various asset classes.

First, what is the federal funds rate?

The key lending rate in the US is known as the federal funds rate. Using this rate, banks and other financial institutions borrow money from each other for ultra-short loans. This is why it is also known as the overnight loan rate.

Banks and other institutions use these loans to bolster their cash reserves for the day. Every morning, the lenders attempt to forecast their liquidity requirements. If there is a deficit in their holdings, they borrow money from other banks and pay it back the next day with the interest added.

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Why does the Fed control this?

The Federal Reserve (and other central banks) tweak the lending rate in an attempt to control inflation. If the range of the Federal funds rate is raised, it increases the cost of borrowing the money.

Banks usually pass the higher interest rates on to the consumer, which makes paying back loans more expensive for them. In an economy with high inflation, it ensures consumers are either paying more to the bank or reluctant to make big-ticket purchases such as cars or homes. This helps to keep inflation in check.

The Federal Reserve has indicated it will cut rates three times and stock markets surged. How does this work?

When the cost of borrowing rises, large companies that take loans to fund their growth plans or daily operations will have to pay more to service their existing debt or when taking fresh loans. This reduces their profit margin and hence earnings.

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Also, when interest rates rise, consumers cut back on their spending. This can hurt demand and hence revenues of companies. When corporate earnings fall, many investors reduce their exposure to stocks.
Other asset classes begin to look more lucrative, as their return potential goes up and the risk to reward ratio tilts in their favor.

However, the opposite happens when the Federal Reserve indicates it will cut rates. Borrowing becomes cheaper, investors have more money in their hands and the other asset classes pale in comparison. A confluence of these factors is what sent the Wall Street’s key indices surging to record highs when investors assumed the Fed would cut rates.

Why are bond prices rising after the rate cut assumptions? Why are yields falling?

The interest rate and bonds have an inverse relationship: when the interest rate rises, the price of the bond goes down.

That sounds complicated. 

Most bonds are issued at a fixed coupon, also known as interest rate or yield. This is the return the purchasers of the bond receive for their investment. Let’s assume a company ABC has issued a bond of $100 with a coupon of 10 percent.

However, interest rates have risen and the company ABC is in urgent need of capital. It issues a new bond of $100 with a coupon of 11 percent.

Using simple interest, over the course of 10 years, the first bond would pay out $200, while the second would give $210.

Why would any savvy investor buy the first bond for the same price, when they receive better returns on the second? Therefore, the price of the first bond will go down.

The reverse tends to occur when the interest rates go down. In such a scenario, the older bonds offering higher returns are in demand with investors. So the prices of those bonds rise.

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Gold hit a record high too. What is the connection with the Federal Reserve? 

Conventional wisdom has it when interest rates rise, money flows into bonds and other fixed-income instruments. As a result, gold prices should fall. Therefore, when the Federal Reserve hikes its lending rate, it is bad news for gold.

However, contrary to expectations, there isn't a determined relationship between interest rates and gold. Gold prices fluctuate based on global cues, so while the Federal Reserve's decisions can impact gold prices, there is no long-term, stable relationship between the two.

What is the impact of changing interest rates on the dollar and how does it tie into the inflation situation?

The dollar sees strength and weakness in proportion to the federal funds rate. As the interest rate is raised, the country will see more inflows from foreign investors. To invest in America, they will have to convert their local currency to the dollar, which strengthens the greenback.

If the dollar strengthens following an interest rate, fewer countries will be willing to accept exports from America. The US companies will attempt to import goods at a cheaper price, which will lead to it being retailed for a cheaper price. To compete with foreign goods, American companies will have to slash prices, leading to consumers paying less and therefore, helping curb inflation.

What does a hike in US interest rates mean for emerging market equities, including Indian shares?

Typically, when interest rates on US government bonds go up, it is negative for emerging market equities. That is because some money moves out of emerging markets into US government bonds, which offer a better rate of return as well as risk free returns.

However, this relationship does not always hold. For instance, if emerging markets give good returns, foreign investors may prefer to stay put. The Indian market attracted huge foreign inflows last year despite interest rates in the US going up sharply.

A quick recap: higher interest rates are good for the dollar and bond yields but push equities and gold down. The opposite occurs when interest rates fall.

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