Is Australia Caught in a Federal Reserve Vice?

  • Stock markets and interest rates exhibit a historical inverse relationship
  • The Australian stock market moves in lock and step with the US
  • As the Federal Reserve has attempted to squeeze out inflation through rate rises, the Australian share market has retreated. Is there an end in sight?

Through a challenging nine months of Australian equity ownership, the stock market has broadly given up the gains of 2021. The S&P ASX 200 has returned to the open of 2021 and is currently trading at 6,729 as of Thursday morning.

Fair warning

That is not to say that policymakers didn’t give fair warning in the retracement. The Federal Reserve has been raising baseline lending rates in the US for six consecutive months.

The Fed funds (the Federal Reserve interest rate target) rate and the key US stock benchmark index, the S&P 500, exhibit an inverse relationship. When rates are rising, the stock market falls and vice versa.

This relationship doesn’t tell us much in the time of a fiat currency and general economic expansion. Then let us look at the relationship between the same index and periods when the Federal Reserve raises rates for three or more consecutive months.

With such a scenario, the underlying stock price movements can be explained by rates. The normal month-to-month correlation between the Fed funds rate and S&P500 is -0.62, the absolute increases to -0.7 when rates have risen for three consecutive months.

Intuitively this makes sense; the market is too hot, and the Federal Reserve is putting on the brakes.

Trade winds

There is a strong historical relationship between the Australian and US stock markets. The monthly S&P500 and ASX200 correlation is a high 0.84, with a scale of 0 to 1. A coefficient of 0.84 implies that Australia sneezes when the US catches a cold.

The Federal Reserve is actively raising the Fed funds rate and, by extension, the cost of capital. Corporate boards are putting ideas of capital expenditure and expansion on the back burner.

With immediate growth opportunities throttled, equity valuations have responded in kind.

The S&P 500 is down 18% this year, and Australia has trailed that return with a more modest 10% markdown in its benchmark ASX200 index.

Australia has been among the few inflationary beneficiaries of record raw material prices. As countries hit the red line, the gains are expected to be ephemeral.

Loosening of shackles

In July, the Federal Reserve signalled a benchmark target rate of between 2% & 3% by September. We are currently at 2.5% and entering what could be considered a period of reflection in the inflation data.

Crude oil benchmarks are down over 25% from the June highs, and there appears to be some stabilisation in other inflation indicators.

The ISM Manufacturing Prices Paid in August was down 52.5 versus a reading of 60 in July. The ISM Prices Paid represent business sentiment regarding future inflation. A downtick in services is being reflected in the data as well. ISM Services Paid reading 71.5 versus 72.3 in July.

With prices stabilising, the probability increases that the Federal Reserve will be satisfied with this round of rate rises. Hopefully, we can envisage a near future with the shackles loosened if not released entirely from the stock market.

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