What does a rising Fed Funds Rate mean for US equities?

By Peter Garnry, Head of Equity Strategy, Saxo Bank

The FOMC decided yesterday to hike the Fed Funds Rate for the first time since the pandemic started. The overall message was in line with previous statements striking a hawkish tone. The dot-plot rose to suggest seven rate hikes this year and a terminal rate of 2.75% which is above the neutral rate currently estimated at 2.38%.

What does a higher Fed Funds Rate mean for US equities?

Using data on US equity returns, US Treasury returns, and the effective Fed Funds Rate (FFR) we can get an idea of the historical relationship. In this period (1973-2022) we have 589 monthly observations with around 300 being an unchanged or negative month in terms change in the effective FFR while we have 289 observation in which the effective FFR rises. The average monthly US equity return is 1.43% during months when the effective FFR is up and 0.29% when the effective FFR is down; the difference in means have a t-statistic value of 3.15 or p-value of 0.0017. Subtracting the risk-free return (return on US Treasuries) we get an excess monthly return of 0.77% when the effective FFR is rising and -0.16% during months when the effective FFR is declining; the difference in means have a t-statistic value of 2.47 or p-value of 0.014.

In other words, US equities deliver a significantly higher return and excess return over US Treasuries during periods of rising effective FFR. If history repeats itself, this bodes well for equity returns, but one caveat is that equity valuations remain above their historical average adding headwinds if they continue to mean-revert on the outlook for inflation and prolonged war in Ukraine.

Peter Garnry

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