Will the US Federal Reserve cause the stock market to fall further?

All other central banks will take their cues from the Fed.

The Indian stock market has been in panic for the past week or so… and for good reason.

The main reason for such a boom in the markets since March 2020 was the easy inflow of money into them.

This easy money was created and supplied by central banks around the world, led by the most important central bank, the US Federal Reserve.

As long as interest rates remained low and the liquidity tap remained open, financial markets around the world kept going up.

Investors and traders were not worried about a major crash in spite of COVID, as they knew that easy money would continue to flow. Thus, ‘buy dip’ was the theme driving the market.

The recent fall in the market has been attributed to the US Fed’s inclination to reverse the policy.

Over the past few months, the Fed has signaled its intention to end the era of easy money. They would do this by raising interest rates and taking back the money they had provided from the market.

In the markets, this is called ‘tapering’ or ‘taper’.

Many central banks around the world have already raised interest rates, the most prominent being the Bank of England.

In a two-day meeting on January 25-26, the US Fed will make its decision on interest rates and liquidity withdrawals.

Markets aren’t necessarily concerned about the announcement per se. They know it is inevitable.

The cause for concern is the speed of these moves.

Markets fear a rapid reversal of easy currency policy. To be specific, the concerns are about how fast the Fed will raise interest rates and the date by which it wants to completely reverse all the money supply, that is, the stimulus it has provided since 2020.

All other central banks will take their cues from the Fed. If the Fed announces an aggressive reversal of its policy, markets will assume that all other major economies will do the same.

This would mean a sharp rise in interest rates around the world and a lot of pressure on asset prices, including stocks.

Indian market is closed tomorrow on account of Republic Day. So they will respond on Thursday, January 27. The Fed would have announced its policy before the opening of the Indian market, either late Wednesday evening or early Thursday.

So how will the market react?

Well there are some possibilities…

First, there is the important question about interest rates.

The US market does not expect the Fed to raise rates in this meeting. Instead it expects the first hike at the next meeting in March 2022.

The meeting expects the US market to announce the start of the rate hike cycle in March and a timeline for future rate hikes.

Investors and traders are very interested in knowing two things: the magnitude of the move as well as the duration. They want to know whether the Fed will raise rates in steps of 0.25% or 0.5%. Also, for how long will the Fed continue to hike rates? 2023? 2024? Tall?

Then there is the massive overhang of all the money printed by the Fed and supplied to the markets. How will it be taken back? And how soon?

Along with the Indian market, all the stock markets around the world are nervous about these questions. If the US market reacts negatively to any announcement, every other country will have a similar reaction.

For example, the Fed may decide to raise interest rates at this meeting itself. This may indicate an aggressive policy of rate hikes, say 0.5% at every meeting this year. The market is expecting only 4 rate hikes this year. If the Fed announces more, the market will react badly.

In such a situation, FIIs will sell aggressively.

Then on the question of return of liquidity, the market does not expect anything aggressive from the Fed. It expects the Fed to announce the start of this process in the second half of the year. Some on Wall Street think the Fed may delay the return of liquidity until the end of the year.

What if the Fed doesn’t oblige and instead announces a plan for quicker withdrawals of easy funds?

So in such a situation, you can expect a sharp fall in the stock market on Thursday.

In the financial markets, he says, ‘when America sneezes, the world catches a cold’. This has been true for a very long time. There is no reason to expect the situation to be any different this time.

But what about the long term?

Will the Fed’s action change the market trend? Will a bear market replace a bull market? Will we see a crash like in 2020?

These are valid concerns but long-term investors can rest assured that they do not need to change their investment strategy.

As long as you have purchased high quality stocks at a good margin of safety, the stocks will perform well over the long term.

However, if one of these is missing, the fundamentals of quality or margin of safety, the reversal of liquidity will take its toll on these stocks. Low quality stocks as well as stocks offering no margin of safety can see significant downside.

We recommend looking through your portfolio thoroughly to separate the weeds from the flowers.

Rest assured, the editors of Equitymaster will get in touch with you in case of a sharp downturn in the market.

Disclaimer: This article is for informational purposes only. This is not a stock recommendation and should not be treated as such.

(This article is syndicated from Equitymaster.com)

(This story has not been edited by NDTV staff and is auto-generated from a syndicated feed.)


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