Congress has tasked the Federal Reserve with the job of keeping the U.S. economy running as smoothly as possible.
If the Fed believes the economy is lagging, it can cut the federal funds rate to make borrowing money cheaper for individuals and businesses. This move typically pushes up stock prices, rewarding investors better returns.
The first months of the Covid-19 crisis provide the most recent example of this dynamic. In early 2020, the outbreak of the pandemic drove a shockingly massive and rapid decline in economic activity, attended by the fastest stock market drop in history. The Fed responded by slashing rates as low as they go—and the economy and stocks came storming back.
But what happens to stocks when the Fed raises interest rates?
The Impact of Fed Interest Rate Hikes
When inflation runs too hot or asset bubbles get out of hand, the Fed raises interest rates to cool things off.
Higher rates ripple throughout the entire economy. Mortgages, car loans and business loans become more expensive, slowing down cash flows. This can lead businesses to amend or pause plans for growth.
In the stock market, higher rates can incentivize investors to sell assets and to take profits, especially in times like now when there’s been a few years of double-digit percentage returns on stocks. As you might guess, investor decisions like this can lower stock prices—individually, at least, if not across major market sectors.
What’s more, if interest rates rise high enough, boring savings instruments like high-yield savings accounts or certificates of deposit (CDs) might start looking more attractive to some conservative investors.
Do Stock Markets Fall when Interest Rates Rise?
Here’s the thing about the U.S. stock market and interest rate hikes. If you try to find data showing a correlation between rising rates and falling markets, you might be disappointed.
Dow Jones Market Data recently analyzed the five most recent rate hike cycles to see what history says about stock market returns in these periods. Their analysis—duplicated in the chart below—illustrates that during these five long-term periods, the three leading stock market indexes only declined during one rate hike cycle.
When factored together, the S&P 500 saw a median increase across all five cycles of 30%, while the Nasdaq delivered a median gain of nearly 27% and the Dow Jones industrial Average (DJIA) delivered a median increase of 17.4%.
During the series of rate hikes from June 29, 2004, to Sept. 17, 2007, for example, the federal funds rate soared from 1.0% to 5.25%—and the DJIA gained 28.7%.
You don’t have to reach back that far to find evidence that challenges the idea that rising rates lead to falling stocks. In 2017, the Fed raised rates three times—and the S&P 500 climbed more than 18%.
The Short-Term Impact of Higher Rates on Stocks
Is this picture different in the short term? Do investors immediately go scurrying for the exits when the Fed makes its announcement, but then things improve over time? We’ve all seen dramatic correspondents breathlessly announcing Fed meeting results over scratchy phone lines, as market stats dive into the red.
A look at the the performance of the S&P 500 over the nine Fed rate hikes between December 2015 and December 2018 tells an ambiguous story.
When the Fed announced a rate hike on Dec. 13, 2017, the S&P 500 dropped 0.5% over the next day, but gained 4.6% after one month. On the other hand, the rate increase on Sept. 26, 2018 hike saw the benchmark index gain marginally over the next day, but fall 8.5% after one month.
Unlike the long-term picture above, short-term market moves after Fed rate hikes present a pretty mixed bag of results. For day traders, that’s cold comfort. But for buy-and-hold stock market investors with a longer time horizon, the message is pretty clear: Fed rate hikes aren’t a bad thing.
The Dynamics Behind Rate Hikes and Stock Performance
When trying to divine which way the market may move, it’s important to keep in mind that rate hikes don’t hurt everyone equally. In fact, they can help certain sectors, like financial stocks. If you are in the business of lending money, higher rates mean higher margins.
On the other hand, rising rates tend to hurt growth stocks, like tech startups. In uncertain markets, investors tend to look for stable companies, like commodities, Dow Jones stalwarts or even older, established tech firms.
These companies tend to pay dividends, which insure some growth even if share price drops. High-growth companies usually put their cash into expanding the business, and they tend to churn through cash, so high borrowing costs can really clip their wings.
That’s why difficult markets can favor selective investors—sometimes called “stock pickers”—who happen to guess the right companies and industries to invest in as market conditions change.
But it’s pretty tricky to get the timing right, even for professionals, because not only are you contending with any actions the Fed makes but also those of other investors as well, many of whom have already priced rate hikes into their trading calculations.
So if you think you should trade based on the expected increase that will be announced at the March 15-16 Fed meeting, for instance, you’re probably far too late for that chess move.
But take heart, investors. While the Fed overnight lending rate matters, it is hardly the only thing that impacts stock market returns.
That’s a large part of why experts recommend most people hold diversified portfolios of large index funds. This way, you already have exposure to short-term winners (even if it means you also hold some losers), come what may. And that helps position you to be a winner long term.