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Look at Real Interest Rates

While we watched Federal Reserve operations last week, it came after the central bank watched rising inflation for nearly two years.

The initial rate hike of 0.25% is a tentative step towards the struggle that the central bank hoped to avoid.

The Fed appears to have been concerned about the policy change because of the impact that higher interest rates could have on the stock market. Since 1987, it has explicitly supported higher stock prices. Economists It is believed that the effect of wealth associated with higher prices drives consumer spending.

The Fed’s concerns about the stock market are well-founded. Rising interest rates can hurt stock prices at times.

But that is not the case now.

Real interest rates and the stock market

By keeping interest rates low, the Fed allowed the inflation rate to move above its interest rate.

The chart below shows the difference between exchange rates on 10-year banknotes and inflation, an indicator known as “real interest rates”.

Usually the interest rate is above inflation. This results in a positive real interest rate, which is shown in black at the bottom of the chart.

In the last two years, interest rates have failed to keep pace with inflation. Negative real interest rate is shown in red.

Deep in negative territory

At the top of the graph, the black line is the S&P 500. The blue line is the Fed interest rate, the index interest rate that the Fed controls. Blue stripes highlight the times when they were negative.

The chart shows that stocks rise as the Fed raises interest rates while real interest rates are negative. Shares tend to fall when the Fed lowers interest rates in the same scenario.

Now, the rising interest rate is bullish. But the Fed needs to stick to its policy decision for now.

If the central bank does not start reducing its balance sheet or delaying future gains, the shares will be sold because traders doubt the Fed’s commitment to fight inflation.


Michael Carrhe The editor of Masters of True Options, One Trade, Peak Velocity TraderandPrecision gains. He teaches technical analysis and quantitative technical analysis at the New York Financial Institute. Follow him on Twitter@MichaelCarrGuru.

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