Inflation, Fed Interest Rates, Dollar Index and the Market Explained
A general understanding of the market movement
Background
Following the Russian invasion of Ukraine on 24th February 2022, the world economy was thrown into chaos. We have witnessed the multitude of sanctions imposed on Russia by several countries and Russia’s retaliation in response to the sanctions.
Russia’s foreign reserves were frozen, the value of the ruble crashed by 30% and the inflation rate of Russia's economy rose by 14%, forcing the Russian government to increase interest rates by a whopping 20%. The ban on Russian oil and gas imports causes the prices of oil per barrel to skyrocket. There were also speculations of a Russian bond default as a result of Russia’s frozen foreign reserves, further decreasing investors’ confidence and causing a mass selling of Russian assets.
Just recently, Russia is demanding that “unfriendly” countries are to pay for oil and gas in rubles and announced that future bond coupons would be paid out in rubles instead of dollars.
As a passive retail investor myself, I began to wonder: interest rates, inflation and dollar index — what does it all mean? How are they related to each other and how is the market affected by it?
Historical Data Collection from Multiple Sources
Understanding the correlation between the four key components will allow us to understand the big picture of market movement. We will be collecting 4 key historical financial datasets in .csv format, cleaning and aggregating them. The four key datasets and sources are:
- S&P 500 index: Tracks the performance of 500 large companies listed on the US stock market. The index generally reflects economic health. Link
- Dollar index: Tracks the performance of US dollar. The index goes up when the US dollar appreciates and vice versa. Link
- Inflation, PCE: An increase in inflation rate is indicative of an overheating economy and generally Feds would increase interest rates to counter this. Link
- Fed Interest Rate: Also known as the Fed Fund Rate, it is determined by the FOMC in response to the status of the economy. Link
First, we store names of the four .csv files in a list data_files and initialize a function to load and store them in a dictionary df_dict.
All attribute names would need to be stripped of white spaces and be in lower caps using .lower() and .strip(). The date attribute would then be standardized and converted to pandas datetime object via .pd.to_datetime function.
All the date formats are the same (day first, 19/03/2010) and we can specify the parse date order dayfirst = True under datetime function.
It is important to note that during this process of aggregating data from multiple sources, different date attributes might not be in the same format.
Data Cleaning, Wrangling and Aggregation
Taking a closer look at the collected historical datasets, we observed that the historical data dates all the way back to 1954. Do we need the data all the way back to 1954? This really depends on the goal of our analysis. We know that there are two key financial crises in the last 20 years, namely the collapse of the Lehman Brothers and the Covid-19 recession and we will filter the data for the last 20 years.
The historical data is collected in daily frequency and in the string data type (e.g. “4,234”). We can condense it by looking at the monthly moving average using .resample(“MS”) and convert each field to appropriate datatype by float(i.replace(“,”, “”).
Additionally, it is critical to understand that it is not recommended to compare the absolute values amongst the four datasets as the scale of values largely differs. For example Dollar Index of 118.92 and the S&P 500 index of 3,272 could be all-time highs, but both values are on a different scale. Instead, we should calculate Year over Year and Quarter over Quarter percentage comparison.
Finally, after running all the functions and renaming attributes appropriately, the four datasets will be aggregated and merged into one via reduce function under functools library and export as .csv file.
What Does It All Mean?
During the Great Recession (fueled by the collapse of Lehman Brothers) and the Covid-19 Recession, both inflation and interest rates fell. At the same time, the Dollar appreciated and S&P 500 Index crashed.
Based on graph, inflation rate and Dollar Index are inversely related. Similarly, Dollar Index and S&P 500 are inversely related. However, inflation and interest rate are not always directly related.
Unexpectedly, right after the Covid-19 recession (Feb — Apr 2020), inflation skyrocketed, the dollar index fell and the market rallied, indicating that the economy is recovering. However, this is untrue as unemployment rates are extremely high and the economy is still suffering from supply-chain disruptions and border restrictions. Hence, the Feds did not increase interest rates even though inflation is high.
Thank you for taking the time to go through the article. Hopefully this analysis helps passive retail investors like myself understand the general market movement a little more.
