The Federal Reserve Just Raised Interest Rates for the First Time Since 2023. Here's What History Says Happens in the Stock Market Next.

Key Points

• High inflation rates pushed the FOMC to raise the target federal funds rate at its September meeting.
• Higher interest rates can negatively affect stock prices for multiple reasons.
• History shows a clear pattern of how markets react to the start of new rate-hike cycles.
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Since taking over the role of Chairman of the Federal Reserve in May, Kevin Warsh has been adamant that he would deliver price stability. In the meantime, inflation has continued to climb higher, moving further away from the Fed's goal of 2% annualized price increases.

In his third Federal Open Market Committee (FOMC) meeting as Chairman, Warsh and the rest of the committee finally acted. They raised the target federal funds rate by a quarter point. The federal funds rate is the overnight rate at which banks borrow cash, and it affects most interest rates in the market. Raising the rate can help curb inflation, but it can also curb corporate earnings and job growth. Balancing the two is the job of the Federal Reserve.

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The rate hike is the first since 2023 and marks the first new rate-hiking cycle since the start of 2022. Here's how the start of a rate-hiking cycle affects the S&P 500 (SNPINDEX: ^GSPC), and what investors can expect this time around.

How do higher interest rates affect stocks?

Theoretically, higher interest rates have multiple effects on the stock market.

Higher interest rates on low-risk bonds should push investors to sell stocks in favor of safer assets that offer higher returns than previously. Of course, financial markets price everything based on expectations, so bond yields had already climbed in anticipation of the Fed's rate hike. For example, 10-year Treasury Bonds recently reached their highest yield since 2007. Despite higher rates, the effect on stock prices has been relatively muted.

Additionally, investors will discount future earnings using a higher risk-free rate. That typically has a bigger effect on growth stocks, where earnings expectations well into the future have a bigger effect on the stock price.

Lastly, higher interest rates could have a meaningful effect on a business's finances if it needs to borrow capital to grow. Today, that can affect both small-cap stocks, which frequently use floating-rate debt to fund their operations, and some of the largest companies in the market. The AI data center build-out is increasingly funded by debt as hyperscalers spend hundreds of billions on new construction and servers.

Indeed, rate hikes should send stock prices lower. More often than not, that's what happens.

Since the end of World War II, the Federal Reserve has had 18 rate hiking cycles. The majority of them instigated a significant drawdown in the S&P 500 into correction territory within 12 months. The average drawdown for the index after the first rate hike of a tightening cycle is 14%, according to research from Charles Schwab. It's important to note that the drawdown may not occur immediately after the first rate hike, but at some point within the first 12 months of the cycle as the effect of rate hikes is fully digested.

Prepare for volatility

A Fed tightening cycle could push stocks lower, but it might not last very long. As the market digests the effect of higher interest rates on both corporate earnings and spending, as well as on inflation, it'll gain a clearer picture of just how high interest rates can climb and how long they could remain elevated. Market uncertainty can have a big negative effect on stock prices as investors err toward safer assets. Right now, the best we have to go on is the Fed's dot-plot, which shows the governors' projections of where they expect the fed funds rate to land in the future.

The FOMC projections show one more rate hike before the end of the year, but rates might not climb much higher, if at all, in 2027. From there, the consensus calls for a gradual lowering in interest rates through 2029. The projections beyond this year remain relatively dispersed, however, indicating a high degree of uncertainty.

If there are only a couple of rate hikes before a pause, it would be the best-case scenario for stocks. Historically, these "non-cycles" have resulted in the smallest drawdowns. Even so, stocks typically recover relatively quickly. The average return 12 months after an initial rate hike is about 6%.

That is to say, rate hikes alone won't turn a bull market into a bear market. Unless the underlying earnings growth pushing stocks higher starts to falter, investors can expect stocks to eventually climb higher, even if the bull ride is a little wilder.

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Charles Schwab is an advertising partner of Motley Fool Money. Adam Levy has positions in Charles Schwab. The Motley Fool recommends Charles Schwab and recommends the following options: short September 2026 $95 calls on Charles Schwab. The Motley Fool has a disclosure policy.