Question

why does the stock market often respond after a FOMC meeting when there are no announced changes in the target Fed funds rate? Do the bond markets respond also? Would you expect them to respond similarly? Why or why not?

Answer 1

The FOMC holds eight regularly scheduled meetings per year. At these meetings, the Committee reviews economic and financial conditions, determines the appropriate stance of monetary policy, and assesses the risks to its long-run goals of price stability and sustainable economic growth. (https://www.federalreserve.gov/monetarypolicy/fomc.htm)

Even though it takes atleast 12 months for any increase or reduction in the interest rates upon the economy, the stock and bond market's response to the change is very quick, almost immediate. (https://www.investopedia.com/investing/how-interest-rates-affect-stock-market/)

It is the Federal Funds Rate that moves the markets. If the rate increases, the cost of funds that the banks can borrow from Federal Reserve increases. It leads to increase in lending rates by banks. Thus, the borrowing cost of everybody (industries as well as consumers) increases. It leads to reduction in profit margins of producers and/ or increase in selling price of goods and services and increase in household expenses.

The Federal Reserve uses the Federal Funds Rate as a tool to control money supply and for other goals mentioned above.

The stock market reacts after a FOMC meeting either by dramatic ups or downs in prices OR continuing on its own pace, as it was going before the meeting. It's dramatic responses occur when the expected stance and/ or the increase/ decrease in interest rate is different from the FOMC meeting's outcome.

• Suppose the market expects rate to reduce, but the FOMC decides to keep the rate as it is, then the markets will react negatively. The prices of the listed companies as well as benchmark indices will fall, unless there are other reasons or news to cheer about.
• Suppose the market expects rate to increase, but the FOMC decides to keep the rate as it is, then the markets will react positively. The prices of the listed companies as well as benchmark indices will increase, unless there are other reasons/ news which are negative for the market.

THE BOND PRICES and FEDERAL FUND RATE

• The Bond prices also respond to the the FOMC meeting outcomes.
• The Bond prices and the Bond yield have inverse relationship. When the yield on bonds increase, the prices decrease and vice versa.
• When Fed Rate increases, the existing T-bondholders and holders of other bonds which are linked to Fed Rates feel that they will get lesser returns on the existing bonds. So, they would like to sell the existing bonds and purchase new bonds with increased interest rate. This will make the existing bonds less attractive, and hence their prices will decrease. But till when? The bond prices will decrease till the point where the yield of bond touches the increased rate. Thus, when rate increases, yield increases, bond price decreases, and vice-versa.
• As in the case of Stock market, the investment community in bond markets also has certain expectations from the upcoming FOMC meeting. These expectations lead to gradual adjustment in the bond-prices, as too in the case of stock markets. If the outcome of meeting is in line with their expectations, there is calm. If expectations are not met, there is immediate movement in prices to correct and match the outcome with the bond-prices.

Thus, the bond market reacts in a similar way, but in opposite directions as compared to the stock market. While the increase in rate causes stock prices to fall, it causes the prices of high yielding bonds to increase due to increased demand. The prices of bonds with low interest rate also reduces as their demand reduces, upto the point where yield matches the increased Rate.