Why Does the Stock Market Drop When the Fed Raises Rates?

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It's OK to be a little fuzzy on this topic. It's also OK to feel a little paranoid if you observed your portfolio losing a lot of value due to the Fed's recent announcements. Just because someone has an IRA or a diverse portfolio, this doesn't mean that they understand the economic underpinnings that cause their portfolio values to rise and fall. In times like these, when just about everyone invested in the stock market is singing the blues, it's important to take some time to better understand various aspects of this complicated system. One key piece in this puzzle is THE FEDERAL RESERVE.

What's Up With the Fed and the Stock Market?

We hear a lot about the Federal Reserve. Politicians tell us that it needs to be broken up and/or audited. News media outlets bloviate about its role in interest rates all around the country. But what specific actions does that Federal Reserve play in the rise and fall of the stock market? If you ask many investors, they won't always have a clear answer for you.

The real answer is multifaceted. While the Fed doesn't impact the stock market directly, it's decisions cause ripples that can make it rise or fall in seconds. Of the many things that the Federal Reserve does, its most important action related to stocks is its control of interest rates. The Federal Funds Rate is set by the Fed. This is the rate of interest that banks charge each other to borrow money. This interest rate is a benchmark for the interest rates extended to ALL BORROWING ENTITIES EVERYWHERE, whenever they borrow money for any purpose.

Because you are not a bank with billions of dollars in available assets, you will be charged more interest for any loan you take out in your lifetime. Banks run almost no risk of defaulting when they borrow money from another bank. You on the other hand...

This means that every person who takes out a mortgage loan, every business who borrows money to expand its operations, every teenager buying their first car: all of these will have interest attached to the loan. And it will always be at least as much as the Federal Funds Rate, usually a lot more.

After the 2008 Financial Bubbleburst, the Fed lowered this rate as far as it could possibly go. They did this because it would motivate people at all levels of the economy to borrow, buy, and invest, thus spurring the economy through the tough times of the Recession. This sort of worked, but growth has recently stalled and economists are split over the best way for the Fed to act in response.

Several months back, you may remember that the Fed raised the interest rate to (as much as) 0.5%. Historically, this is bottom-of-the-barrel low! It's also a sign that the Fed trusts the strength of the economy to support itself, at least somewhat. You've got to remember that this interest rate used to be in the 20's in 1980. If you have bought a house or started a business in the past couple of years, you have enjoyed a rare opportunity.

So Why Does Raising the Interest Rate Make the Stock Market Freak Out?

When it costs more for businesses to expand (due to the higher cost of borrowing), these businesses likely become less valuable to investors. Because the Fed's interest rate impacts every loan that happens in the entire country, no business is unaffected. People who are intimately involved in the stock market start to divest themselves of their suddenly devalued dividend potential, and the entire market drops. It doesn't matter that interest rates are historically low. Any increase hurts stock returns, and thus throws a temporary wrench in the markets.

If you have an IRA or any other investment account, you are feeling the pinch at this moment. So are rich people, like Jeff Bezos. The thing is, the Fed must raise interest rates eventually, and the global market will just have to learn to deal with it. But with so much riding on the Feds' decisions, and no one wanting to repeat or exceed the Recession of 2008, you can understand why the Fed's under some pressure right now.

So What Should I Do?

Don't freak out, please. If all of this comes as a surprise to you, this is an important lesson in the fundamental economics of American investing. And it doesn't mean that the bottom is going to fall out of your portfolio. Hopefully (and nobody can tell the future, no matter what they might say on the internet) the economy will continue to recover, and the stock market will grow based on internal robustness, not artificial support from the Federal Reserve.

As I constantly remind people, sensible stock investing should be about the long game, not about blips in the radar. If you've followed past posts, you know that I always recommend Index Mutual Funds for at least a significant portion of every portfolio. You can track stocks at the new stock directory module on my website, for a closeup look at individual winners and losers. By investing in the strength of the stock market as a whole (the index fund approach) and learning about the inner workings of individual stocks (through the link I suggested), you'll be in a position to survive hard times and make decisions that take full advantage of the good times.

The Fed will do what it does, and it won't always be in the best interests of your short term investment interests. The portrayal above is just one little sliver of what the Fed does. But by better understanding it, you'll be more likely to steer clear of investment fear-mongering, and stay the course to long term investment success!

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