Since the 2008 financial crisis, central banks worldwide have opened their cash gates and flooded the financial markets with billions of new money. The most important instrument in monetary policy is the prime rate for interest rate for central bank money. In an expansionary monetary policy, the rate is lowered to reduce the cost of borrowing and thus to increase the money supply. This should lead indirectly to a boost in economic growth.
The financial markets also follow this logic. When interest rates fall, companies can refinance themselves more cheaply because their borrowing costs decline. In this environment, investors pay higher prices for shares as they expect future rising corporate profits.
The adjacent graph shows the influence the US central bank has on the equity markets. If we subtract the trading days of the S&P 500 before and on the day of the Fed’s interest rate meeting (about 300 days since 1997), the stock index would have achieved a total return of 18% since 1997. Including these days, the plus amounts to an impressive 138%.
This shows how sensitively the markets react to the central bank’s statements. Investors should be aware that the mechanism works on both sides: if interest rates rise, there is the risk of stock price losses. According to Martin E. Zweig, two successive interest rate increases, or an absolute increase of 1%, are a warning sign to reduce risk in the portfolio.