How Stocks Perform Just Before and After a Drastic Fed Interest-Rate Increase

Text size

The Federal Reserve could implement two interest-rate increases in one fell swoop next month. The stock market tends to perform poorly just ahead of that type of move, but things usually get much better for investors afterward. 

The Fed could lift the benchmark lending rate by 50 basis points at the conclusion of its March 15-16 Federal Open Market Committee meeting, essentially equivalent to two hikes because the central bank typically raises rates by 25 basis points. For instance, of the 40 interest-rate increases since 1989, only five were for 50 basis points. The probability of a half-percentage point rate increase is 37%, according to the Fed funds futures market as of Thursday afternoon.

Such a drastic move would reflect the Fed’s concern about high inflation, with consumer prices rising 7.5% on an annual basis in January, a four-decade high. Investors, however, are worried that a rapid rise in short-term rates will lift borrowing costs for households and businesses and in turn reduce economic demand. 

That’s a possibility that the stock market must consider. Historically, the market typically drops right before the Fed issues a steeper-than-normal rate increase.

Dating back to 1994, the

Dow Jones Industrial Average,

S&P 500,
and

Nasdaq Composite
—on average—have fallen 1.2%, 0.8%, and 3%, respectively, over the two-week period just before the Fed raises rates by at least 50 basis points, according to Dow Jones Market Data.

While that could certainly happen to stocks again ahead of the mid-March Fed decision, it isn’t a sure bet. That is because the major indexes are already trading below their all-time highs; the S&P 500, for instance, is down about 8% from its Jan. 3 record. That means there is a chance the market won’t see extended losses in the lead-up to the FOMC announcement, as stocks are already trading at a lower baseline. With the S&P 500 trading above key technical levels, the index is far from danger territory. And when looking out one month leading into a 50-basis-point rate increase, stocks actually tend to gain for that period.

In any event, the stock market usually begins to recover after the Fed announces a rate increase of 50 basis points. On average, three weeks after a Fed announcement, the Dow, S&P 500, and Nasdaq rise 1.4%, 1.3%, and 3%, respectively. The gains get better looking further out, with index advances between 18.7% and 22.5% for the 12 months following the rate decision. 

That makes sense, considering that the Fed’s rate hikes are normally a response to inflation—which often is a result of growing economic demand.

What complicates the picture this year is that some of today’s inflation is because of supply shortages, and not just increased demand. As long as higher interest rates don’t significantly dent economic demand, corporate earnings should be able to keep growing—even if slower than before the rate increases. That should help keep stock prices on the rise.

---

Newsletter Sign-up

Review & Preview

Every weekday evening we highlight the consequential market news of the day and explain what’s likely to matter tomorrow.

---

Now, the Fed is expected to raise interest rates at least more than five times within the next two years—and the central bank’s January minutes released Wednesday revealed that it is likely to raise rates faster than it did between 2015 and 2018.

Write to Jacob Sonenshine at [email protected]

“We are seeing a massive flip in the Fed’s stance,” said Tom Essaye, founder of Sevens Report Research. “What that does to the market is uncertain and it’s going to cause volatility.” 

So while there is a historical stock market pattern around FOMC rate decisions, it isn’t a guarantee that stocks will behave the same way this time around. And, as always, there’s no substitute for monitoring the economic fundamentals on the ground.

Write to Jacob Sonenshine at [email protected]