Why Fed rate hikes have historically dented US stock prices

History suggests US stocks can come under pressure when the Federal Reserve begins raising interest rates, although the eventual market impact depends heavily on how aggressively the central bank hikes and how the broader economy responds.

The Fed last week raised its benchmark interest rate for the first time since 2023, increasing it by 25 basis points as it seeks to contain persistent inflation. The central bank has signalled another increase by the end of the year, while investors are pricing in further hikes in 2027.

The prospect of higher rates matters for equities because tighter monetary policy can raise borrowing costs for companies and consumers while also affecting expectations for economic growth and corporate profits.

“Our bottom line is (whether) the Fed’s actions have an impact on the market’s expectations for either economic growth or corporate profit growth,” David Lefkowitz, head of US equities at UBS Global Wealth Management, said.

What history shows

The S&P 500 has recorded a median decline of 2.6 per cent in the three months following the first rate hike of a Fed cycle, according to LPL Financial data covering six cycles since the Fed began announcing meeting outcomes in 1994.

More from Business

RBC Capital Markets found that in five of those cycles, the S&P 500 suffered declines of between 8 per  cent and 14 per cent from peak levels. The market lows came between one month and three-and-a-half months after the initial hike.

That pattern does not necessarily mean every rate-hike cycle results in a prolonged bear market. Instead, the initial phase of monetary tightening has historically been associated with greater market volatility and periodic corrections. Higher interest rates can affect equities through several channels.

First, more expensive borrowing can weigh on corporate investment and consumer spending, potentially slowing economic growth. Second, higher bond yields can make fixed-income assets relatively more attractive compared with equities.

Higher rates can also put pressure on company valuations, particularly when investors reassess the future earnings growth of businesses.

The key question for markets, therefore, is not simply whether the Fed is raising rates, but how far it needs to go and whether the economy can absorb the tightening.

Why 2022 remains a warning

The rate-hike cycle that began in March 2022 remains particularly relevant for investors. The S&P 500 ultimately entered a bear market that year, falling 25 per cent from its peak and reaching its low roughly seven months after the first rate increase.

Analysts, however, have highlighted important differences between the 2022 episode and the current cycle. The earlier period involved fears of recession and a particularly aggressive pace of monetary tightening.

The Fed raised rates by 525 basis points during the 2022-2023 cycle.

Current cycle looks shallower

The current hiking cycle is expected to be considerably shorter and less aggressive.

Fed funds futures on Wednesday indicated that rates could peak at around 4.8% in a little over a year, implying total tightening of slightly more than 100 basis points.

While rate hikes have often triggered an initial bout of volatility, historical data also show that US stocks have tended to recover.

The S&P 500 was 6.8 per cent higher on a median basis one year after the first rate hike, according to LPL Financial. The index was higher after one year in every cycle examined except the 2022-2023 episode.

The message for investors is that the immediate market reaction to higher rates does not necessarily determine the longer-term trajectory of equities.

The S&P 500 has gained more than 12 per cent so far this year and was near record levels on Wednesday, suggesting that strong corporate earnings have so far helped offset concerns over higher oil prices, rising bond yields and the Fed’s more hawkish stance.

The historical record, therefore, points to two distinct phases: an initial period of potential volatility following a rate hike, followed by a recovery when economic and corporate earnings fundamentals remain resilient.