[Beginner's Guide] What Is the Relationship Between Interest Rate Hikes and the Stock Market?

▲Jerome Powell, Chair of the Federal Reserve (Fed) [Image source=Reuters Yonhap News]

[Asia Economy Reporter Kwon Jaehee] If you have read recent stock market articles, you have probably seen the terms Federal Open Market Committee (FOMC) or Federal Reserve (Fed) frequently. What are the FOMC and Fed, and how are they related to our stock market?

What is the Federal Reserve (Fed)?

To understand the FOMC, you first need to know about the Fed. Simply put, the Fed functions as the central bank, similar to the Bank of Korea in South Korea. Established officially under the Federal Reserve Act passed by the U.S. Congress on December 23, 1913, the Fed consists of 12 regional Federal Reserve Banks, the Board of Governors, and the Federal Open Market Committee (FOMC).

Federal Open Market Committee (FOMC), what is your identity?

[Image source=Reuters Yonhap News]

The FOMC, one of the key components of the Fed, is the institution that decides monetary policy. The Fed holds eight FOMC meetings annually, with the meetings in March, June, September, and December being especially important. This is because critical policies, such as interest rate decisions that can significantly impact the economy, are often made during these meetings.

Possibility of a 50bp hike at the FOMC... What is the correlation with the stock market?

You may have seen articles reporting that the stock market closed lower after Fed Chair Jerome Powell hinted at a big step (a 50bp increase in the benchmark interest rate) at the upcoming May FOMC. So, is an interest rate hike bad news for the stock market?

Generally, when the benchmark interest rate rises, the discount rate applied to corporate earnings increases, and the interest rate on safe assets like deposits also rises, making stocks?considered relatively risky assets?less attractive. For this reason, the stock market tends to experience significant volatility whenever interest rate hikes are mentioned.

[Image source=Yonhap News]

Does an interest rate hike only act as bad news for the stock market?

Now that an interest rate hike is a foregone conclusion, does that mean investors should all leave the stock market? Looking at past cases, that is not necessarily true. In fact, during periods of interest rate hikes, global stock markets have achieved high returns.

Since the 2000s, the Fed has raised benchmark interest rates twice. The first rate hike period was from June 2004 to June 2006, and the second was from December 2015 to December 2018.

During the first rate hike period, global and emerging market stocks rose by 28.9% and 73.3%, respectively. During the same period, the Korean stock market also saw the KOSPI rise by 61% and the KOSDAQ by about 47%. Even when calculated as an annual average return, these figures represent strong returns of 29.3% and 22.7%, respectively.

During the second rate hike period, the global stock market rose by 11.9%, while the KOSPI increased by 2.5% during the same period.

Then, during an interest rate hike period, what kind of stocks should you buy?

[Image source=Yonhap News]

It is difficult to say that the stock market will decline just because interest rates rise. So, what kind of stocks should you buy?

Recent articles have mentioned a differentiated market by stock, advising attention to companies with good earnings and future guidance.

During periods of low interest rates, liquidity was abundant, and the market rose powered by money flow, so growth stocks and technology stocks?expected to show significant growth in the future by raising funds at low interest rates?were favored.

However, in periods of rising interest rates, the appeal of growth stocks diminishes. As interest rates rise, raising funds becomes burdensome, and investments for growth decrease, reducing the value of future earnings.

For this reason, during interest rate hike periods, interest in traditional industries or value stocks increases. This is why companies with strong earnings, attractive dividends, and expected good performance in upcoming quarters have higher value, as recent articles have pointed out.