Will U.S. Federal Reserve Cause Stock Market To Fall More?

The Indian stock market has been nervous for the last week or so...and for good reason.

The main reason why the markets have gone up so much since March 2020, was the easy money flowing 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 stayed low and the liquidity tap remained open, financial markets around the world went up.

Investors and traders weren't concerned about a huge crash, despite Covid, because they knew the flow of easy money would continue. Thus, 'buy the dip' was the theme driving the markets.

The reason for the recent fall in the market has been the US Fed's inclination to reverse this policy.

For the last few months the Fed has signalled its intention to end the era of easy money. They will do this by raising interest rates and withdrawing the money from the market that they had provided.

In the markets, this is called 'tapering' or 'the taper'.

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

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

The markets aren't necessarily worried about the announcement per se. They know it's inevitable.

The cause for worry is the pace of these moves.

The markets fear a swift reversal of the easy money policy. To be specific, the concern is about how fast the Fed will raise interest rates and the date by which it wants to fully reverse supply of all the money, i.e. 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, then the markets will assume 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.

The Indian market is closed tomorrow due to Republic Day. So they will react on Thursday, 27 January. The Fed would have announced its policy before the Indian market opens, either late on Wednesday or early on Thursday.

So how will the market react?

Well there are a few possibilities...

First, there is the key question about interest rates.

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

In this meeting the US market expects the Fed to announce the start of the rate hike cycle in March and also give a timeline for future rate hikes.

Investors and traders are very interested to know two things: the magnitude of the hikes as well as the duration. They want to know if 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? Longer?

Then there is the huge overhang of all the money the Fed has printed and supplied to the markets. How will it be withdrawn? And how fast?

The Indian market, as well as all other stock markets around the world, are nervous about these questions. If the US market were to react negatively to any announcement, there will be a similar reaction in every other country.

For example, the Fed could decide to raise interest rates in this meeting itself. It could signal an aggressive policy of rate hikes, say 0.5% in every meeting this year. The market is only expecting 4 rate hike this year. If the Fed announces more, the markets will react badly.

FIIs will sell aggressively in such a situation.

Then on the question of withdrawal of liquidity, the market doesn't 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 could delay the withdrawal of liquidity to the end of the year.

What if the Fed doesn't oblige and instead announces a plan for a quick withdrawal of easy money?

Well, then you can expect a sharp decline in the stock market on Thursday.

In financial markets, they say, 'When the US 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 different this time.

But what about the long term?

Will the Fed's action change the direct of the market? Will the bull market be replaced by a bear market? Will we see a crash like we did in 2020?

These are legitimate concerns but long term investors can rest assured they don't need to change their investing strategy.

As long as you have bought high quality stocks at a good margin of safety, the stocks will do well in the long term.

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

We recommend taking a good hard look at your portfolio to separate the weeds from the flowers.

Rest assured, Equitymaster's editors will reach out to you in case of a sharp decline in the market.

Disclaimer: This article is for information purposes only. It 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.)