As of this writing, bond investors expect the Federal Reserve to raise interest rates at its next meeting on Sept. 16. Stubborn inflation and strong job growth in August suggest that the Fed will hike interest rates in September.
A classic rule of thumb in investing is that higher interest rates tend to be bad news for stock prices. When investors can earn higher income on bonds, they might be incentivized to move money out of stocks. Does that mean you should sell stocks in case of a September rate hike?
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Not necessarily. Charles Schwab recently published research based on nearly 80 years of data about how Fed interest rate hikes affect stock prices. The story is more complex than “stocks always go down after rate hikes.”
Let’s look at what 80 years of history can show us about rate hikes and stocks — and what long-term investors should do next.
Fed rate hikes tend to lead to stock price declines — but the market bounces back
Charles Schwab researchers looked at data going back to 1946 to see what happens to stock prices after Fed rate hikes. The research found that the S&P 500 index (SNPINDEX: ^GSPC) historically experienced maximum drawdowns averaging -12% within the first six months of the Fed’s first rate hike, and -14% within the first 12 months.
But not every Fed rate hike is the same. It matters how fast the Fed raises rates. The Schwab research also found that when the Fed tightens rates faster, the S&P 500 had an average maximum drawdown of -16% in the first 12 months.
Investors saw this kind of severe drawdown in 2022-2023, when the Fed fought high inflation by rapidly hiking interest rates. As interest rates rose quickly from near zero in January 2022 to 5.33% in summer 2023, the S&P 500 went into a bear market.
Effective Federal Funds Rate data by YCharts
Here’s the good news for stock market investors: Even after a big drawdown, the market tends to bounce back fast. For example, if you had invested in the S&P 500 on Jan. 1, 2022, right before that bad year for stocks, your investment would be up almost 61% today.
Keep in mind that over the very long run, ever since 1928, the S&P 500 has delivered average annual returns of about 10%. That includes economic crises, global conflicts, and times of rapidly rising interest rates. The Vanguard S&P 500 ETF (NYSEMKT: VOO) is one of the most popular exchange-traded funds that lets you own the entire S&P 500. In the past five years, this fund has delivered average annual returns of 12.75%.
