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Many investors seem to have embraced the notion that a pause by the Federal Reserve is good news for the stock market. This view was evident last Friday when a much weaker-than-expected employment report triggered a 140-point rally in the Dow Jones Industrial Average ($INDU). The idea is that, if the Fed is ready to halt in its rate hike campaign, it is good news for the economy, corporate profits, and share prices. However, that enthusiasm might be somewhat unjustified since 1) The Federal Reserve is probably not finished raising rates and 2) Historically, stocks have not performed well in the months after the Fed stopped raising rates.

The Federal Reserve Open Market Committee [FOMC] meets Wednesday afternoon to discuss monetary policy. It is widely believed that the committee will vote to raise the Fed Funds target rate for a sixteenth time in less than two years. The rate hike campaign has been steady and well telegraphed by Fed officials. Since June 2004, the Fed Funds target rate has been notched steadily higher in ¼-point increments, brining it up from a 40-year low of 1% to its current level of 4.75%.   

The idea that the Federal Reserve will take a pause at 5% has been making the rounds for several months. It was solidified late last week when a monthly payroll report showed the US economy adding 138,000 new jobs in April, which was well below economist estimates of 190,000. The surprisingly soft number increased the odds that the Fed would stop raising rates sooner rather than later. The Fed doesn’t want to risk overdoing it—pushing up rates too high and bringing the economy to a grinding halt.

Now, investors will look to the post-FOMC statement on Wednesday for confirmation that the Fed will end rates. According to Briefing. Com’s Chief Economist Dick Green, “Absent any clear sign that the Fed is going to raise rates at the next meeting, the stock market is likely to react favorably to the policy statement, or at least retain its moderately underlying bullish tone.”

However, Green also points out that a pause in June doesn’t necessarily mean the Fed is finished raising rates. In other words, a “pause” doesn’t mean much if the FOMC begins raising rates again in the meetings that follow. According to Karen Talley and Mohammed Hadi of Dow Jones Newswires (“Don’t Count on the Fed to Boost Stocks,” May 7, 2006), “Investors have repeatedly bid up stock prices on a widely held perception, later proven wrong, that the next Fed action would be the last in a series.”

Ironically enough, even in the unlikely event that the Fed is finished raising rates, history has shown that alone is not enough to boost stock prices. In fact, according to statistics gathered by Jason Goepfert of SentimentTrader.com, since 1950, the average return in the Dow Jones Industrials in the six months that follow the end of a rate hike cycle is –2.7%. Basically, stocks generally move lower when the Fed stops raising rates. Not the other way around. The idea that the end of a rate hike cycle is bullish for stocks is not supported by the market’s historical performance.

So, all eyes will be on the FOMC Wednesday and it is quite possible that stocks rally again if the post-meeting statement reinforces the view that the Fed will pause in its rate hike campaign. However, the notion that the end to the rate cycle is bullish for stocks might be somewhat misplaced since 1) there is no assurance that the rate hike cycle is coming to an end and 2) history shows that stocks are more likely to fall, not rise, when the Fed actually does stop raising rates. In conclusion, don’t bet on the Fed.


Frederic Ruffy
Senior Writer & Index Strategist
Optionetics.com ~ Your Options Education Site
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