The United States Federal Reserve has increased the rate of interest on December 13. More increases are to be expected in 2018. Experts surmise that the interest rate will rise by three times in the coming year. These hikes could affect the stock market. Long term rates influence the market more than the short term rates.
The rates, whether short or long, are determined by market demand and the supplies available in that market. These rates cannot be determined by the Federal Reserve. The 10 year Treasury rate and federal funds rate are seen to track each other. These two go through the diverging and converging cycles. Right now the interest rate in the short term seems to catch up with long term rate. If the Federal Reserve increases short rate by end 2018 by a one percent total, then it is possible that 10 year rate will increase less.
The stock market is influenced by the fluctuation of rates. The stock market dips in case of higher interest rates. This is as the higher interest rates result in elevating the discount rates. The fair value of the stocks are thus lowered.
A number of popular valuation metrics like CAPE have labeled stock markets as 'overvalued' from 2010. In case the market is actually overvalued, the interest rate increase will initiate the sell-offs. There are a few caveats in this case. If the rate for federal funds is increased for the maiden time post financial crisis from 0.25 percent to 0.5 percent in December 2015, along with 0.75 percent during December 2016, a few tremors were felt, but the stock market sailed on. Negative impact, if on, were canceled out. The market still continued at its fair value after its continuous rally. The PE metrics overemphasize comparison of historical average. It totally ignores the present economic backdrop. The valuations are usually seen to stay above long term averages in a low-inflation and low-rate environment.
Fair value calculations demonstrate a much better track record when it comes to predicting where the market will go. The calculation uses average borrowing cost and discounting the forward earnings. It is seen that during the latter part of the 1990s and during the earlier part of the 2000s, the Standard & Poor was extremely overvalued. The index subsequently dropped back to the fair value.