The S&P/ASX 200 (ASX: XJO) is up 1.44% at the time of writing as the market reacts positively to an overnight interest rate rise from the US Federal Reserve.
The tech index is up a whopping 3.67%, which has been offset by a 0.22% fall in energy companies.
The Federal Reserve is the central bank of the United States and is equivalent to the Reserve Bank of Australia (RBA).
What did the Federal Reserve announce?
At its policy meeting, The Fed increased interest rates 25 basis points, from 0.25% to 0.50%.
Some commentators were expecting a 50 basis point rise to tame rising inflation across the globe.
In his commentary, Chairman Jerome Powell said he expects six further rate rises in 2022 until the interest rate reaches between 1.75% to 2.00%.
It’s the first time since 2018 that interest rates have increased. Zooming out further, interest rates have been falling since the 1980s.
The central bank also cuts its growth forecasts, raised inflation estimates, and said it would cut back bond purchases.
In simple terms the economy is slowing, goods are more expensive and borrowing costs are going up.
“We understand that high inflation imposes significant hardship, especially on those least able to meet the higher costs of essentials like food, housing, and transportation” – Jerome Powell
How do interest rates impact the ASX 200?
Interest rates are an important input to valuing ASX 200 companies.
It’s considered the ‘risk-free rate’, which is what investors can invest at with zero risk.
To illustrate, let’s say you can store your cash in a savings account earning 0.50% interest.
Your other option is to buy Commonwealth Bank of Australia (ASX: CBA), which you think will earn a 5.00% return.
If interest rates rise to 3.00%, the 5.00% return CBA is offering doesn’t look nearly as attractive.
Subsequently, you would expect either a higher rate of return for CBA or a lower price to compensate for the risk.
That’s why investors are concerned about the ASX 200 at the moment. If interest rates rise, this could mean falling shares prices.
But the market reacted positively to two aspects of the announcement. The first is certainty around current and future rates rises.
The second is the positive commentary by Mr. Powell regarding the American economy.
“The American economy is very strong and well positioned to handle tighter monetary policy” – Jerome Powell
Hence why the ASX 200 is jumping for joy today.
