The U.S. Federal Reserve is tasked with keeping inflation under control, which typically means targeting an annual increase of around 2% in the Consumer Price Index (CPI). When inflation is too high, it puts pressure on household budgets and reduces corporate profit margins, so the Fed often hikes the federal funds rate (overnight interest rates) to put the brakes on the economy and cool prices down.
The CPI rose at an annualized rate of 3.4% in August, prompting the Fed to hike rates for the first time in three years at its September meeting. Fed chairman Kevin Warsh also warned more rate increases might be on the way if inflation remains persistently high, and the latest batch of data suggests that is exactly what is happening.
Rising interest rates can spell bad news for the stock market for a few reasons. In fact, the Fed’s last rate-hiking cycle resulted in a bear-market decline of over 20% in the S&P 500 (^GSPC +0.58%) index. Here’s what investors need to know.
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Inflation is moving in the wrong direction
The U.S. and Iran have been locked in a fierce geopolitical conflict since late February. In an attempt to gain leverage, Iran has closed the Strait of Hormuz waterway, through which 25% of the world’s seaborne oil transits each day. To make matters worse, the ongoing conflict between Saudi Arabia and Yemen took a turn for the worse recently, knocking even more oil supply offline.
As a result, a single barrel of West Texas Intermediate crude trades for over $100 as I write this (Oct. 19), a whopping 77% increase from its 2026 opening price of $57. Consumers now face soaring prices at the pump, but they are also paying more for groceries and retail products because it’s suddenly more expensive to fuel the trucks, boats, and planes used to transport them.
The CPI increased at an accelerated annualized rate of 3.7% in September, with the energy component jumping by 20.4%. But it could get worse, because the September Producer Price Index (PPI) increased by 6.3%, with energy surging by 35.4%. The PPI measures the change in input costs for businesses, which are typically passed on to consumers through higher prices, so it’s often a leading indicator of future CPI readings.
The CME Group‘s FedWatch tool, which tracks the probability of interest rate moves by analyzing the 30-day Fed Funds Futures market, suggests there is a 91% chance of another 25 basis-point hike in December. It also predicts two more hikes in March and June 2027, so it seems Wall Street is betting that high inflation is here to stay.
Today’s Change
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Rising interest rates are bad news for the stock market
When interest rates rise, consumers are forced to allocate more of their household budgets to debt repayments, leaving less money for discretionary spending. Over a long enough period of time, this can put a dent in corporate earnings, and earnings typically drive stock prices.
High interest rates also make companies think twice about borrowing money to fund their expansion plans, so investors start pricing in slower sales and earnings growth, which often leads to lower stock prices. Better yields on risk-free alternatives like cash and government Treasury bonds only accelerates the shift away from stocks when the growth outlook is uncertain.
The Fed’s last rate-hiking cycle spanned from March 2022 to August 2023, and the S&P 500 was down more than 20% at its lowest point during that period, officially placing it in a bear market.
It’s impossible to predict how long the Fed’s current hiking cycle will last, but the S&P 500 is especially vulnerable to a correction right now because of its valuation. It’s trading at a Shiller Cyclically Adjusted Price-to-Earnings (CAPE) ratio of 41, the second-highest level behind only the peak of the dot-com bubble in the year 2000. In fact, the index’s CAPE ratio is so high that it might still be expensive even after a bear-market decline of 20%.
As a result, investors should tread with caution right now, particularly if they are trading risky derivatives like options contracts, or using margin loans to amplify their returns. These practices can lead to substantial losses if volatility ramps up.
The best approach is to stay focused on the long term. History suggests the market tends to recover and set new highs given enough time, so using a potential dip to buy an S&P 500 index fund and consistently adding to the position could yield excellent results over a period of 10 years or more.
