The U.S. Federal Reserve hiked the interest rate by 25 basis points and plans six more hikes this year to curb inflation. This news drove the stock market. The Nasdaq Composite Index and the TSX 60 Index surged over 3% and 1.27%, respectively, in the second half of the March 16th trading session.
The Fed expects to increase the interest rate to 1.75-2% by year-end and reduce 2022 inflation to 4.3%. These measures come as the U.S. inflation peaked 7.9% in February, the highest since January 1982’s 8.4% inflation amid a recession.
Correlation between the Fed interest rate and stock markets
When Fed increases interest rates, the equity premium becomes less attractive for investors. They sell risky investments and invest in low-risk bonds and other debt securities. Why is there this inverse relation?
The Fed uses interest rates and Treasury bonds to control the money supply in the economy and, therefore, inflation. When it wants to reduce liquidity in the market, it makes borrowing expensive by increasing interest rates. It also sells Treasury bonds to pull money out of the economy and into its reserve.
Hedge funds see interest rate hikes as an indicator of reduced liquidity in the future. When people have low liquidity, they spend cautiously and sell risky investments. Hence, the stock market sees a dip when the interest rate surge for the first time. However, the stock market gradually increases, as investors tend to price in future rate hikes.
Why did the stock market surge after the Fed rate hike?
When the Fed announced the interest rate hike yesterday, the U.S. and Canadian stock markets jumped. The jump came as the market had already priced in an aggressive rate hike. In January, hedge funds sold tech stocks over fears of an interest rate hike. The market has already priced in aggressive rate hikes. As the suspense is over, investors jumped to buy tech stocks that bottomed out in the selloff.
Apart from the interest rate hike, the Russia-Ukraine war is affecting the stock market and the economy. Rising inflation is an effect of war. Inflation is rising not because of excess liquidity but because of high oil and energy prices amid the war.
The United States and Russia have imposed sanctions on each other, thereby disrupting the global supply chain. Airplanes and ships have to re-route to avoid Russian airspace and seas. Europe and the United States are seeking alternative suppliers for several goods. All this will increase the prices of imported goods. Even the Fed expects a 4.3% inflation this year — more than double its target inflation of 2% and higher than the market forecast of 3.5%.
There is fear that aggressive interest rate hikes could lead to recession if the war intensifies.
How could the U.S. market impact Canadian investors?
The United States is the biggest trading partner of Canada and has a direct impact on the capital inflow from U.S. investors. A high-inflation market bodes well for energy and commodities and a rising interest rate for bank stocks. In this market, you can benefit from three ETFs:
iShares S&P/TSX Capped Energy Index ETF (TSX: XEG) invests in 22 Canadian oil and gas companies. It has 50% holdings in Canada’s two largest integrated oil companies: Canadian Natural Resources and Suncor Energy. The oil price touched US$125/barrel before cooling to US$99. When the winter season comes, the demand for oil and natural gas will surge, and if the supply doesn’t increase, oil prices could surge.
BMO Equal Weight Banks Index (TSX: ZEB) ETF has holdings in the Big Six banks of Canada. Many have large exposure in the United States. Higher interest rates benefit a bank’s loan arm but adversely impact its wealth management arm. But the Big Six banks still earn a major portion of their income from loan interest and therefore benefit from a Fed rate hike.
This is also a good time to buy tech stocks nearing their bottom, with iShares S&P/TSX Capped Information Tech Index ETF (TSX: XIT). The ETF invests almost half of its holdings in application software, including blockchain and software-as-a-service. Tech stocks might remain volatile in the short term, but they will resume growth and ride the secular trends of 5G, autonomous cars, and artificial intelligence (AI) in the long term.
