Key insights
- The real Fed Funds rate (Fed Funds rate minus CPI) is negative, incentivizing risk-taking. Historical data suggests a negative correlation between negative real rates and stock market performance over the subsequent six months. This increases the likelihood of future Fed rate hikes, which could act as a headwind for equity valuations.
When the Fed Funds rate is below CPI, short-term safe money market funds are not keeping up with inflation. This creates an incentive to take more risk than people might be inclined normally.
The data on what this means for the stock market over the next 3 months, 6 months, 12 months is mixed. The reality is that it introduces an increased likelihood that the Fed will raise short-term interest rates vs lower them which would be a headwind for stock prices as higher rates usually lead to lower PEs.
This forum does not allow images so I will just report that the last 4 times Fed Funds real rate was negative, the stock market was down between 1.6% to 7.9% six month later. Those periods began 12/11/2007, 11/30/2009, 11/30/2015 and 10/31/2019.
Why is this a topic for r/ValueInvesting? Because interest rates have a direct effect on the valuations investors are willing to pay for risk assets. This is a fundamental tenet of modern finance theory and history bears it out, just not always in the short-term.