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The Impact Of Federal Reserve Decisions On Financial Markets 

The decisions made by the Federal Reserve, particularly regarding interest rates, can really shake things up, and although the Federal Reserve’s most recent meeting left investors with the hope of possible cuts happening this year, the current feeling is still uncertain as there is still the possibility of rate cuts not happening at all.

The reaction from different markets can vary depending on whether rate cuts materialize or not, and this is exactly why investors should consider the implications that either scenario unfolding.

So, let’s say that the Federal Reserve does decide to cut interest rates:

This, in essence, means that it becomes cheaper to borrow money, which can lead to people and businesses to spend and invest more.

In this scenario, in regards to the stock market, the response tends to be positive. This is because with cheaper borrowing costs, businesses may be more inclined to expand their operations, invest in new projects, and boost their overall profitability. This tends to be a positive sign for investors as the focus on growth and expansion means that the companies are confident about their performance, and this in turn, can result in higher demand for stocks, leading to increased stock prices and potentially higher returns for investors.

For the bond market, it reacts in different directions. In terms of existing bond prices, they tend to increase, and this is because as interest rates fall, the coupon rate (fixed interest rate that a bond issuer promises to pay to bondholders over the life of the bond) for existing bonds will be higher than the one from newly issued bonds. Consequently, the demand for existing bonds will increase, driving their prices up. Therefore, if you decide to sell your bonds before they mature, you could potentially sell them at a higher price than the price you initially paid, and even if you do not sell them, the increase in bond prices contributes to the overall value of your investment portfolio. In simple words, if you currently hold a bond, and the Fed goes ahead with the rate cuts, you will make profit. However, as just stated, new bond issuances will not be as appealing for investors due to their lower coupon rates.

It is worth noting that although in regards to long term and short term bonds, both increase in price if interest rates are lower, since longer term bonds are more sensitive, long term bonds experience a larger price increase than shorter ones, and this is because they have a longer time for the higher coupon rates to add up. Therefore, in this scenario, if you compare a 2-year bond to a 10-year bond, the rise in price value will be more significant for the 10-year bond.

Moreover, in terms of bond yields it is very important to keep in mind that they will decrease. This aspect is essentially relevant for new bond investors looking to purchase bonds after a rate cut is implemented, as lower yields mean that the return they would receive is lower compared to the original yield offered by the bond. This principle of yields falling as interest rates decrease also applies to other fixed-income investments like savings accounts and certificates of deposit (CDs) as with regard to interest rate reductions, yields on savings accounts and CDs likewise decline. As a result, investors earn less interest on their savings and deposits.

Also, taking into account that traditional investments, such as the ones just mentioned, tend to offer lower returns in a low-interest rate environment, investors may be driven to seek higher potential returns by turning to riskier assets. This interest shift towards riskier assets will increase the demand in cryptocurrencies, which, in essence, also increases their price.

In addition, since lower interest rates can lead to increased liquidity, which results in more money circulating and making it easier for traders and investors to buy or sell assets across different market conditions, in the case of the crypto market, this enhanced liquidity can play a crucial role in boosting investor confidence by fostering stability and trust. This is because traders and investors can enter or exit positions in cryptos more easily, reducing the risk of price slippage and making it easier to trade in various market conditions.

Nonetheless, it is important to keep in mind that regardless of rate cuts happening or not investing in cryptos still carries inherent risks such as regulatory uncertainties and security concerns.

For the forex market, central bank decisions to cut interest rates often signal instability for their respective currencies, therefore, if the Fed chooses to follow suit, the value of the U.S. dollar could take a negative hit. This is because reduced interest rates decrease the attractiveness of holding U.S. dollars as they no longer yield as much interest. Consequently, there may be diminished demand for the dollar as investors seek higher returns elsewhere, potentially causing a depreciation of the U.S. dollar against other currencies.

Also, since a weakening dollar can make assets priced in U.S. dollars more affordable for buyers using stronger currencies, markets such as commodities can benefit from this. The reason behind this is that due to increased affordability, demand for commodities can increase, leading to higher prices.

Additionally, as stated by Goldman Sachs, rate cuts in non-recessionary environments tend to drive up commodity prices considering that lower borrowing costs can stimulate manufacturing growth. Therefore, metals like copper, gold, aluminium, as well as crude oil, grains and cocoa, are likely to rise – there are even expectations for commodities to rise by around 15% over the year despite the ongoing geopolitical risks.

However, it is worth noting that as for all markets, the performance of commodities is influenced by a wider range of factors, therefore, changes in rates may not affect all commodities equally. For instance, Goldman Sachs analysts currently caution against loading up on every commodity, as they have a bearish view for natural gas and lithium, and anticipate little change for nickel and zinc.

Now, considering the opposite scenario, with the Fed choosing to raise interest rates, opposite reactions may occur:

Central banks, like the Fed, frequently opt to increase interest rates as a means of controlling inflation, and these moves are usually made during strong economic environments where there is confidence in the economy’s resilience to withstand higher borrowing costs. Such a vote of confidence often leads to an appreciation of the U.S. dollar, making it a preferred choice when compared with other currencies due to its potential to offer higher returns.

And if the value of the dollar increases, then as for the other scenario, the opposite reaction tend to happen to commodities. This is because, a stronger dollar usually makes commodities like gold more expensive. Consequently, the demand for commodities would likely decrease, having a negative direct impact on their prices.

Furthermore, as higher interest rates can possibly slow down the economy due to higher borrowing costs, traditional fixed-income investments become more appealing than higher-risk investments. This is because businesses may postpone their expansion plans and individuals may cut back on spending, and in such an environment, investors tend to shift towards safer investments that will provide a more stable return. This shift in preference is likely to drive up the demand for investments such as bonds and savings accounts, thereby pushing their yields higher.

Meanwhile, higher-risk assets like stocks and cryptos may see a decrease in demand, and this is because these investments are typically more volatile and are more sensitive to changes in market sentiment. If investors are cautious or uncertain about the future, then they may opt to reduce their exposure to higher-risk assets to protect their capital. Therefore, if rate hikes are implemented, there is a likelihood of a decrease in demand for these assets, which will ultimately push down their value.

Lastly, although the bond market can gain more attention during rate hikes due to its stable returns, it is important to understand that the value for existing bonds is likely to decrease. This is because there will be lower demand for existing bonds as their coupon rates are lower compared to the higher coupon rates offered by bonds created post rate hikes. As a result, newly issued bonds with higher yields will become more appealing, and if you hold an existing bond and decide to sell it before it matures, you may have to sell it at a lower price than what you initially paid for it, which will result in a loss for you.

Additionally, in terms of short term and long term bonds, the characteristic of longer-term bonds being more sensitive to rate changes will play against them, as long-term bonds typically experience higher price declines compared to short-term bonds. This is because bondholders are locked into the lower coupon interest payments for a longer period of time. Therefore, selling a 10-year bond before maturity would likely result in a higher loss than selling a 2-year bond.

Ultimately, although the performance of each market depends on its respective dynamics and unique factors, the bottom line is that the decisions made by the Fed can flip the script on the financial landscape in the blink of an eye, and that is precisely why it is crucial to understand the potential trajectories of each market in response to the Fed’s actions. By doing so, you can position yourself to take action swiftly and decisively, regardless of which way the Fed leans.

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