MILLBURN, N.J. ( Stockpickr) -- The Federal Reserve Board surprised the financial markets last month when it announced that it would increase the discount rate. As I discussed yesterday, the immediate market reaction was negative. It was not surprising that so many people thought it was the beginning of Armageddon. After all, the uninformed observer does not know the difference between the discount rate and the fed funds target, the latter of which is far more meaningful when it comes to interest-rate-related behavior. In this installment of The Finance Professor, I will elucidate the difference between key lending rates and how the markets react to increases in interest rates. The discount rate is the rate that the Federal Reserve charges its member banks to borrow short-term funds through a facility called the discount window. The discount window is hardly used by banks. During the financial crisis, it was accessed more often than usual, but that crisis has abated. The credit rate, called the federal funds rate, which is the reference rate for lending activity, is the rate at which banks will conduct their lending activity to other banks. In turn, the federal funds rate is the basis for the prime lending rate (or prime rate). The prime rate is the rate at which banks lend money to their best customers. Other customers will pay rates in excess of (or a spread to the) prime rate, depending on the bank's lending criteria. The Federal Open Market Committee's interest rate policies tend to follow cyclical patterns. During periods of slow economic activity, the FOMC will lower interest rates over a prolonged period of time. This is referred to as an easing cycle. We are currently at the end of an easing cycle that began on Sept. 19, 2007. Easing cycles end when monetary accommodation is removed from the banking system as the FOMC increases its federal funds target rate. As the FOMC continues to increase rates, that is considered a tightening cycle. Thus, the whole hullabaloo in February was about the perception of a tightening cycle finally commencing. While the Fed's February action sparked concerns of an imminent end to accommodating monetary policy by raising or tightening the federal funds rates, such a decision is left to the Federal Open Market Committee. It is really no secret that the FOMC will begin to tighten. The uncertainty is when that will occur. The FOMC is meeting to discuss monetary policy this week. Today, at about 2:15 p.m. EDT, the FOMC will release a statement that incorporates the committee decision as to the federal funds target rate and its short-term economic outlook.
So how have the markets reacted to the beginning of a new tightening cycle? I went back to my data base of daily S&P 500 (SPX) closing prices and identified the last three tightening cycles, dating back to 1994. I also identified the dates in which the first three increases in the federal funds target rate took place during those tightening cycles. From each of those dates, I calculated the price change of the SPX for one, two, three and six months and one year after the tightening decision were made. Here are the results of that analysis: From the above, we see several patterns emerging from the beginning of new tightening cycles. These patterns could help to devise trading strategies once the FOMC does pull the trigger and begins to raise rates. 1. The first tightening appears to have an immediate negative impact upon the SPX. The trough of the post-tightening reaction appears to be two to three months after the first tightening announcement. After that point, the SPX begins to regain lost ground and will likely end up higher within six months to a year from the initial tightening. 2. The second tightening tends to occur at the meeting immediately following the first tightening. Please note that the FOMC meetings are roughly six weeks apart. The second tightening produces the deepest initial decline in the SPX. The trough is one month after the second tightening, which coincides with the trough after the first tightening. Within six months of the second tightening, the SPX will likely be higher. One year after the second tightening, expect the SPX to be even higher than those levels. 3. By the time the third tightening occurs, there is no longer any surprise as to the course of action that the FOMC has embarked on. The economy is beginning to pick up speed, and it's likely that jobs are being created. If by now you are still worried about higher interest rates, the historical track record of the market will prove you wrong should you continue to remain bearish. The third tightening is the signal to get long the SPX. -- Written by Scott Rothbort in Millburn, N.J.