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The Federal Reserve (Fed) will announce its interest rate decision on Wednesday, March 22, after its two-day policy meeting. This will be one of the most closely watched events of the week, as investors and analysts try to gauge how the Fed will balance its inflation-fighting mandate with the financial stability risks posed by the recent banking crisis.

The Fed has raised its benchmark overnight interest rate by 450 basis points since last March, bringing it to a range of 4.5%-4.75%. The Fed’s tightening campaign has been driven by its concern over high inflation, which reached 6% year-over-year in February, well above its 2% target. The Fed has also signaled that it expects to raise rates further this year, possibly reaching a peak of 5.25%-5.5%.

How do Interest Rates affect the stock market?

The Federal Reserve (Fed) sets the interest rate that banks charge each other for overnight loans, known as the federal funds rate. This rate affects the cost of borrowing money for individuals and businesses, which in turn influences their spending and investment decisions. When the Fed raises interest rates, it makes borrowing more expensive and reduces the money supply in the economy. This can slow down economic growth and lower corporate earnings, which may negatively affect stock prices. Conversely, when the Fed lowers interest rates, it makes borrowing cheaper and increases the money supply in the economy. This can stimulate economic growth and boost corporate earnings, which may positively affect stock prices. However, other factors such as inflation expectations, market sentiment, and global events can also influence how stocks react to changes in interest rates.

How would the stock markets react if there is a slowdown (25 bps hike) or a pause?

Market participants have speculated that the Fed may pause or slow down its rate hikes in light of the turmoil in the banking sector triggered by the collapse of Silicon Valley Bank (SVB) earlier this month. SVB’s failure exposed vulnerabilities in some regional banks and prompted emergency interventions from regulators and other banks to prevent a wider contagion. The Fed itself provided record amounts of liquidity to banks through its discount window and other facilities.

The question is whether the Fed will see the banking crisis as a temporary shock that can be contained by macro-prudential measures, or as a sign that its monetary policy has become too restrictive and is hurting financial conditions and economic growth. The answer will depend on how confident the Fed is that inflation pressures are moderating and that its past rate hikes are having their desired effect.

According to Reuters data, traders of U.S. rate futures have firmed up bets that the Fed will raise interest rates by 25 basis points next week, slashing the probability of a pause to about one chance in five. This reflects recent data showing continued strength in the labor market and housing indicators, as well as signs that inflation may be slowing down slightly.

However, Bloomberg notes that it is still a tough call for the Fed given the ongoing uncertainty about financial stability and lending conditions. Some economists argue that raising rates further could exacerbate stress in some parts of the banking system and hamper credit availability for businesses and consumers.

What would be the effect on stock markets if the Fed takes a pause or hikes rates by 25 basis points? A pause could be seen as a positive signal for stocks, as it would imply that the Fed is mindful of financial risks and willing to support economic growth amid headwinds from higher energy prices and supply chain disruptions. A pause could also ease some upward pressure on bond yields and borrowing costs.

On the other hand, a hike could be seen as a negative signal for stocks, as it would suggest that inflation remains elevated and poses a threat to corporate profits and consumer spending power. A hike could also trigger more volatility in bond markets and currency markets.

However, these effects may not be straightforward or lasting depending on how investors interpret them within their broader expectations about future monetary policy paths. For instance, if investors believe that hiking now would allow the Fed to end its tightening cycle sooner rather than later, they may view it favorably for stocks over time.

Ultimately, what matters most for stock markets is not just what the Fed does next week but what it says about its outlook for inflation, growth, and financial stability – especially given recent developments in the banking sector -and how it communicates its policy strategy going forward.

Milan Vaishnav, CMT,  MSTA,
Technical Analyst,
Member: (CMT Association, USA | CSTA, Canada | STA, UK) | (Research Analyst, SEBI Reg. No. INH000003341)