What Happens to the Stock Market When the Fed Raises Rates?

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When the Fed raises rates, stocks often weaken in the short run, but a rate hike on its own has not reliably ended rising markets. According to an LPL Financial analysis of the six Fed rate-increase cycles since 1994, the S&P 500 posted negative average returns in the first four months after the first hike. Over the full 12 months it averaged a gain of nearly 7%, with a median gain near 11%. Averages hide wide variation, though. In the most recent cycle, which began in 2022 as the pandemic era ended, stocks were lower a year after the first hike. The outcome depends less on the hike itself than on why the Fed is hiking, how much the market already expected it, and whether the economy is heading toward a recession.

Why higher rates put pressure on stock prices

The Federal Reserve’s main policy tool is the target range for the federal funds rate, the rate banks charge each other for overnight loans. The Federal Open Market Committee (FOMC) sets it at eight scheduled meetings a year, in steps measured in basis points (a 25 basis point hike lifts the range by a quarter of a percentage point). The Fed raises rates mainly to cool inflation.

A higher fed funds rate ripples into stocks through several channels.

Valuation. A stock’s price reflects the value today of the cash flows investors expect the company to generate in the future. Those future cash flows are discounted at a rate tied to prevailing interest rates. When rates rise, the discount rate rises, and the same stream of expected profits is worth less today. This hits companies whose profits are expected far in the future hardest, because discounting compounds over more years.

Borrowing costs. Companies that rely on debt pay more to refinance and to fund expansion. Higher interest expense comes straight out of earnings. Consumers face higher rates on credit cards, auto loans and mortgages, which can slow spending on cars, homes and other big purchases.

Competition from safer assets. When Treasury bills, CDs and money market funds pay more, investors need a larger expected return to justify the risk of owning stocks. One common comparison is the S&P 500’s earnings yield (earnings divided by price) against the 10-year Treasury yield. If bond yields rise while earnings stay flat, the gap narrows and stocks look less attractive by that measure, unless prices fall.

Economic growth. The point of a hike is to slow demand enough to bring inflation down. Slower demand eventually means slower revenue growth for many companies. If the Fed overshoots, the slowdown can turn into a recession, which is when stock declines have tended to be deepest.

These effects work with a lag. Monetary policy acts with “long and variable lags,” so a hike’s full impact on hiring, spending and profits can take many months to show up.

A worked example: how a higher discount rate changes a stock’s value

The simplest valuation model, the Gordon growth (dividend discount) model, shows the mechanism directly:

Price = Next year’s dividend ÷ (Required return − Dividend growth rate)

Hypothetical example, for illustration only: a company is expected to pay a $5 dividend next year, growing 3% a year indefinitely.

• If investors require an 8% return: $5 ÷ (0.08 − 0.03) = $100
• If higher interest rates push the required return to 9%: $5 ÷ (0.09 − 0.03) = $83.33

Nothing about the business changed, yet a one-point rise in the required return cut the model’s value by about 17%. Real markets reprice continuously, and rates and growth expectations move together, but the direction of the effect is the same.

What history shows after the first hike

The six cycles in the LPL study began in 1994, 1997, 1999, 2004, 2015 and 2022, and they played out very differently:

• 1994: The Fed doubled the fed funds rate from 3% to 6% within about a year, catching bond markets off guard and triggering a sharp bond selloff. Stocks went sideways for much of the year, then the economy avoided recession and the late 1990s bull market followed.
• 1997: A single quarter-point hike in March was followed by a 12-month S&P 500 gain of more than 40%. Because other cycles produced meaningful losses, the 12-month mean (nearly 7%) sits below the median (near 11%).
• 1999 to 2000: The Fed raised rates into a speculative technology boom. The dot-com bust and the 2001 recession followed, and the S&P 500 entered a multiyear bear market.
• 2004 to 2006: The Fed raised rates 17 consecutive times in quarter-point steps, from 1% to 5.25%. The gradual, well-telegraphed pace coincided with a continued stock market expansion.
• 2015 to 2018: The first hike in nearly a decade came in December 2015. Stocks advanced through much of the cycle, though they sold off sharply in late 2018 as investors worried the Fed was tightening too far.
• 2022 to 2023: The Fed began hiking in March 2022 to fight the highest inflation in about four decades, eventually lifting the target range to 5.25% to 5.50% by July 2023. The S&P 500 fell roughly 19% in calendar 2022, one of its worst years since 2008, and was lower 12 months after the first hike.

Six cycles is a small sample, and each began in a different economic setting. History describes what has happened, not what will happen next time.

Why the reason for the hike matters more than the hike

As the LPL strategist behind the study put it, rate hikes don’t typically derail bull markets, but hikes that coincide with rising recession risk are a different story.

When the Fed raises rates because the economy is strong, earnings are often growing fast enough to offset the higher discount rate. The 2004 cycle fits this description. When the Fed raises rates aggressively because inflation is already high, it may need to slow the economy sharply, and investors face both lower valuations and weaker earnings at once. The 2022 cycle fits this description. The 1999 cycle shows a third risk: hikes landing on a market whose valuations had already stretched far beyond earnings.

Will the market go up or down when the Fed raises rates tomorrow?

There is no reliable answer for a single day, because markets react to surprises. Traders price Fed decisions in advance through fed funds futures, and CME Group’s FedWatch converts those prices into implied probabilities for each possible move. If a quarter-point hike is priced as close to certain, it is mostly reflected in stock prices before the announcement.

What moves stocks on decision day is usually new information:

• The size of the move versus expectations. A half-point hike when a quarter point was expected tends to be read as hawkish.
• The policy statement, especially changes in language about future hikes or inflation.
• The Summary of Economic Projections and dot plot, released at four of the eight meetings, which show where FOMC members expect rates to go.
• The chair’s press conference, which can shift the market’s read of the decision within minutes.

This is why stocks sometimes rise on the day of a hike: the decision may be less aggressive than feared, or the Fed may hint that it is close to finished. The reverse also happens when a hike comes with signals of more tightening ahead.

Which stocks can gain from a rate hike, and which tend to lose

Are rate increases better for bank stocks?

Higher rates can help banks, but not automatically. A bank earns a spread between what it collects on loans and securities and what it pays depositors, known as net interest margin. When rates rise, loan yields often reset higher faster than deposit rates, which can widen that margin. Over time, though, depositors move money to higher-paying accounts and money market funds, raising the bank’s funding costs.

Higher rates also reduce the market value of bonds a bank already owns. In March 2023, Silicon Valley Bank failed after losses on long-dated securities combined with a rapid outflow of deposits. Rising rates can also increase loan defaults. Whether a hike helps a particular bank depends on its mix of loans, securities and deposits.

Other potential beneficiaries

• Insurers invest premiums they hold before paying claims, so higher yields can raise their investment income.
• Brokerages can earn more on uninvested client cash.
• Companies with large cash balances and little debt earn more interest and face less refinancing pressure.
• Value stocks, whose worth rests more on current earnings than on distant growth, are less exposed to the discount-rate effect than high-growth stocks.

Groups that tend to face more pressure

• Long-duration growth stocks, including many unprofitable technology firms, because more of their value depends on profits far in the future.
• Utilities and real estate investment trusts, which investors often hold for income and which compete with rising bond yields. Many also carry significant debt.
• Homebuilders and other housing-related businesses, as mortgage rates rise and affordability falls.
• Small companies with floating-rate debt, whose interest costs rise quickly.

FAQs

The Bottom Line

Stock investors watching Fed meetings should focus on why the Fed is hiking and whether a recession looks likely, since history shows hikes alone rarely end bull markets. Decision-day moves mostly reflect surprises versus what futures already priced in. Sector exposure matters as well, because banks, insurers and value stocks respond differently than debt-heavy or long-duration growth companies.