The Federal Reserve raises interest rates by 0.25 percentage points each time, and the S&P 500 index falls by an average of 2.5%.
Why does the stock market fall in response to interest rate hikes?
Whenever the Federal Reserve announces a rate hike, data shows that every 0.25 percentage point increase in interest rates leads to an average 2.5% drop in the S&P 500 index. Firstly, higher interest rates mean increased borrowing costs. For example, during the rate hike cycle from 2004 to 2006, borrowing costs rose by over 20%, and in June 2006, the rate hike led to a 3% drop in the S&P 500 index.
Rate hikes also make fixed-income products (such as bonds) more attractive. After the Federal Reserve raised rates in December 2015, bond yields increased by 1%, while the stock market fell by 5% within a month.
In history, the Federal Reserve’s sudden rate hike in 1987 triggered “Black Monday,” with the Dow Jones index plummeting 22% in a single day.
Entrepreneur Warren Buffett once said, “When interest rates rise, the pricing of all assets is affected, especially stocks.” For instance, due to the high growth and high debt rates of tech stocks, the Nasdaq index fell by 12% within a month under the expectation of a Federal Reserve rate hike in 2022.
The impact of rising interest rates on the stock market
According to a research report by JPMorgan, every 1 percentage point increase in interest rates raises the average borrowing cost for businesses by 30%. For example, after multiple rate hikes by the Federal Reserve in 2018, the overall earnings growth rate of the S&P 500 index dropped from 14% to 10%. Data shows that during the Federal Reserve’s rate hikes in 2022, market liquidity declined by 15%.
Goldman’s research indicates that every time interest rates rise, investor risk appetite decreases by 10%. During the Federal Reserve’s rate hikes in 2018 and 2019, the yield on 10-year U.S. Treasury bonds rose by 2%, while the Dow Jones index fell by 6% over the same period.
During the rate hike cycle from 2004 to 2006, the annual growth rate of the S&P 500 index dropped from 10% to 4%. Boeing postponed several expansion plans in 2018 due to rate hikes. Famous economist John Maynard Keynes once pointed out, “Interest rates are the price of capital. When the price rises, demand naturally decreases.” Taking tech stocks as an example, the Nasdaq index fell by 15% in a quarter in 2018.
Lessons from the past
Over the past 50 years, the Federal Reserve has undertaken a total of 17 rate hike cycles, during which the stock market experienced varying degrees of decline over 60% of the time. From 1973 to 1974, the Federal Reserve repeatedly raised rates to as high as 13%, leading to a 50% plunge in the S&P 500 index over two years.
In the early 1980s, Federal Reserve Chairman Paul Volcker significantly raised interest rates to 20% to curb inflation, but this also triggered the 1982 recession, with the Dow Jones index falling nearly 25% between 1981 and 1982. From 1994 to 1995, the Federal Reserve gradually raised interest rates from 3% to 6%, and the S&P 500 index rose by 34% for the entire year of 1995.
Entering the 21st century, from 2004 to 2006, the Federal Reserve raised interest rates 17 times in a row, raising the rate from 1% to 5.25%. This led to the subprime mortgage crisis and the global financial crisis from 2007 to 2008, with the S&P 500 index falling nearly 50% between 2007 and 2009.
From 2015 to 2018, the Federal Reserve gradually raised interest rates from 0.25% to 2.5%. For example, the rate hike in December 2018 caused the S&P 500 index to fall by 9% within a month. Investment guru Peter Lynch once said, “The market always reflects future expectations, not the current situation.”
