Yellin’ at Yellen: Using Tableau to See How the Fed Rate Affects Markets

Tuesday, September 15, 2015 - 09:30
In 2015, major news outlets have been heating up, speculating about an imminent rise in interest rates. Some have suggested rates should have been raised months ago. Others say that the global economy may be stuck in a perpetual state of low rates, and that the seemingly impossible negative interest rates experienced in the EU are here to stay.
 
But, truly understanding these predictions and arguments often requires a deep understanding of various political and economic factors that can elude even the savviest of analysts. Many investors are concerned about recent events that can make any portfolio volatile (China’s lackluster performance, unrest in the Middle East, sabre-rattling by North Korea, QE in the EU, etc). But my largest apprehension is how the Fed rate increase could impact the markets.
 
In many cases, the typical equity retail investor typically doesn’t care about the all of the quantitative modeling and political maneuvering. They just want to know “What does the Fed’s upcoming rate decision mean to me?” The answer might be simpler than most would expect: in the long run, probably not all that much.
 

Getting The Equity Data Together

There are many investment vehicles that may be affected by a rate change, but I wanted to take a look specifically at how the rate change may affect equities.
 
Normally, as rates increase, bonds become relatively more attractive, so we can expect an outflow of cash from equities to fixed income instruments. I decided to look at the just the numbers and remove the speculation.
 
I downloaded the Federal Funds Rate data from the Fed’s website and S&P 500 historical data (a generally accepted indicator of overall equity market performance) from Yahoo Finance. And after some data munging and aggregating in MySQL, I hooked up the data to Tableau and created some exploratory visualizations. The results were quite comforting.
 

World Events, The Fed Rate Change, and Market Performance

First, I took a look at how the market had performed over time in conjunction with the Fed rate. In blue is the average federal funds rate for each month in a given year. In green is the average monthly value of the S&P 500 in a given year. Lastly, in orange is the average monthly return of the S&P 500 for each year. 
 
 
This graph shows a couple important points:

1. It highlights the Fed’s recent strategy of cutting rates in the presence of a negative economic shock (Vietnam War & Oil Crisis, Dotcom Bust, Great Recession). And each time the Fed has cut its rates, the value of the S&P has climbed again. Though it is important to note that correlation does not mean causation. I am not suggesting that the rate cuts were solely responsible for the economic rebound. There are many other factors to consider as well. 

2. Over time, the value of the market shows accelerating growth. So take a deep breath, grab a coffee and remember that your retirement is years away, and unless the US implodes, you’re probably going to see more growth in the long term.

The Macro trends of continuous market growth and Fed policy are easily portrayed. What is less obvious is how they are co-dependent.
 

The Fed Rate Change and Market Returns

The chart below shows the same concept depicted at two different grains: annual (left) and monthly (right). On the top row we can see how the Fed rate has been altered over the years. The middle row shows the monthly return trends for the S&P 500 index.
 
 
Most important to note here is that while a Fed rate change can trigger a strong equity market response, it is usually short lived and not very significant. We see that the market return data appears to be independent of the federal funds rate. The trend line shows that market return is pretty steady over time. A p-value of almost .9 suggests that there is no real relationship over time between Fed rates and average monthly return. Historically, your money is going to earn a real return in the long run no matter what the Fed does.
 

How The Market May Be Affected: Volatility

The bottom row shows a measure of market volatility over time. Over each month, I took the high and low values of the S&P index and normalized them based on the value at the beginning of each month. These charts display the percentage swing of the S&P 500 in each month (or an average of those swings for a year on the left). This comparison is a little more interesting. 
 
There appears to be a positive trend over time. This suggests that market volatility might be increasing over time. The p-value of the trend line is .14. While that value is not generally considered statistically significant for high confidence levels, it is low enough to cause me to think twice. Market return over time appears independent of the Fed policies, but is market volatility also?
 
To answer that last question, I needed to eliminate the time series aspect of the analysis and just take a look at the federal funds rate and how it does or doesn’t affect the market.
 
 
As it turns out, there is a positive correlation between the federal funds rate and market volatility. This means that to a certain degree, as the Fed raises rates, volatility in the market does increase. If you’re a day trader, this is going to have a major impact, which is why the decision has gotten so much press. But again, if your money is stowed away for the long haul, this isn’t worrisome.
 
We also see a slight negative correlation between the Fed rate and market returns, this correlation is quite small and given the p-value discussed earlier, probably negligible. However, there is some truth to the relationship. As rates rise, the opportunity cost of holding equity vs fixed income rises as well. So we do expect that as rates rise, equity returns suffer slightly as more conservative investors shift some of their capital into fixed income instruments.
 

Time To Panic?

To sum it all up, what does the Fed’s decision mean for you and your retirement? Probably not very much if you aren’t planning on retiring anytime soon. The markets look as though they will continue to trend up regardless of what the Fed decides on September 16th.
 
I’d like to highlight that more analysis on this could be done. It did not take all factors into account, nor did it take a particularly deep dive into the conclusions suggested. This exploration is merely a piece to spark conversation and to provide easy to understand visuals for those who want to become better informed of the interrelatedness of the Fed and the equity market.
 
But in the end, it doesn’t look like it’s worth panicking over the Fed’s rate change. There may be a few ups and downs immediately around the event, but long term investors should probably just stay the course. 
 

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