Trevor Jennewine, The Motley Fool
5 min read
The U.S. stock market has performed well in the past year, in large part because of enthusiasm surrounding the artificial intelligence trade. The S&P 500 (SNPINDEX: ^GSPC) and Nasdaq Composite (NASDAQINDEX: ^IXIC) are up 20% and 27%, respectively, since June 2025. But investors recently got some bad news from the Federal Reserve.
Fed officials now anticipate at least one interest rate increase in 2026. That would mark the beginning of the fifth rate-increase cycle since 1999, and the last four cycles generally coincided with bear markets.
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The odds of interest-rate increases in 2026 have increased substantially
In December, the Federal Reserve lowered the target range on its benchmark interest rate to 3.5% to 3.75%, representing a quarter-point reduction. At the time, the market anticipated at least two more quarter-point rate cuts in 2026, according to CME Group‘s FedWatch tool. But investors’ expectations have changed because of the recent acceleration in inflation.
“The most natural path for the Federal Open Market Committee (FOMC) is to delay further cuts until the effects of tariffs, higher oil prices and other effects of the war in the Middle East, and the effects of artificial intelligence demand have faded,” Goldman Sachs strategists wrote in early June.
The FOMC’s latest economic projections reinforce that idea. The dot plot published after the June meeting indicates that 50% of Fed officials now believe at least one quarter-point rate increase will be necessary in 2026. That’s up from zero in March. Moreover, about one-third of Fed officials expect at least two quarter-point rate increases this year.
Rate-increase cycles have frequently coincided with stock market corrections
Warren Buffett believes interest rates, especially those on Treasury bonds, are the single most influential variable in determining stock market valuations over time. Low interest rates generally make stocks more attractive, while high interest rates tend to make stocks less attractive. Interest rates have a direct and indirect impact on equities.
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The direct impact involves the compression of valuation multiples. In theory, a stock is worth the sum of its future earnings discounted to present value. Higher interest rates reduce the present value of future earnings, which compresses valuations because investors aren’t willing to pay as much for stocks when relatively safe bonds offer reasonably good returns.
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The indirect impact involves higher borrowing costs. Business investments and consumer spending tend to slow when interest rates rise because it’s more expensive to finance projects and purchases. In turn, corporate profits tend to grow more slowly, which can put downward pressure on stocks because equities are often valued based on earnings.
