US stocks could face renewed volatility as investors assess how far the Federal Reserve may need to raise interest rates and whether tighter monetary policy will weigh on economic growth and corporate earnings, Reuters reported.
The Federal Reserve raised its benchmark interest rate by 25 basis points last week to 3.75%-4%, marking its first rate increase in more than three years. The central bank also signalled that further tightening could follow as it seeks to bring persistently high inflation back toward its 2% target. Reuters reported that 16 of 18 Fed policymakers projected at least one additional rate increase by the end of 2026.
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History points to initial stock-market weakness
Historical data suggest that equities can come under pressure during the early stages of a Federal Reserve tightening cycle. According to LPL Financial data cited by Reuters, the S&P 500 has recorded a median decline of 2.6% in the three months following the first rate hike across six tightening cycles since 1994.
RBC Capital Markets' analysis, also cited by Reuters, found that five of those cycles saw declines of between 8% and 14% from the S&P 500's peak, with the lows gexnerally occurring between one and three-and-a-half months after the initial hike.
The experience of 2022 remains particularly relevant for investors. The S&P 500 eventually entered a bear market during that tightening cycle, falling 25% from its peak. The episode was accompanied by an aggressive series of rate increases and growing concerns about a recession.
Read more: US market ends down as oil prices, Treasury yields rise
2022 offers a different template
Market strategists have highlighted differences between the current environment and the 2022-23 tightening cycle. The Federal Reserve raised rates by 525 basis points during that period, a substantially larger increase than the amount currently expected by investors.
Reuters reported that current market pricing indicated the federal funds rate could peak at around 4.8% over the next year, implying a little more than 100 basis points of additional tightening. By comparison, the average rate-hiking cycle since 1983 has lasted just under two years and involved roughly 320 basis points of increases, according to data cited by Reuters.
The pace and scale of the tightening therefore remain central to the market outlook. Investors are also watching whether higher borrowing costs begin to weaken consumer demand, business investment and employment.
Earnings and economic growth remain key
The impact of higher interest rates on corporate earnings could determine how stocks respond beyond the initial period of uncertainty. Strong profits have so far helped US equities withstand several headwinds, including elevated oil prices, rising Treasury yields and expectations of additional Fed tightening.
Reuters reported that US stocks rebounded after the Fed's September decision, with the S&P 500 gaining 1.14% on September 17 while the Nasdaq rose 1.69%. Technology stocks led the advance as oil prices eased and Treasury yields declined.
However, the subsequent rise in Treasury yields has kept pressure on equities. Reuters reported that the benchmark US 10-year Treasury yield moved above 5% during the week, while oil prices remained above $100 a barrel, adding to concerns about persistent inflation.
Despite the initial weakness that often follows the start of a tightening cycle, historical performance has not necessarily pointed to prolonged declines.
LPL Financial data cited by Reuters showed that the S&P 500 was 6.8% higher on a median basis one year after the first rate increase. The index was positive one year after the initial hike in every cycle examined except the 2022-23 episode.
That pattern suggests that the longer-term performance of equities can depend more heavily on whether economic and earnings growth remain resilient as borrowing costs rise.
Investors turn to economic data
With the Fed now in a tightening phase, investors are likely to pay closer attention to indicators that can reveal whether higher rates are beginning to slow the economy.
Manufacturing activity, new orders, employment data, inflation readings and corporate earnings are among the indicators that could influence expectations for the Fed's next moves. Reuters reported that investors are becoming increasingly sensitive to both growth and inflation data as they attempt to determine the eventual impact of the rate-hike cycle on stocks.
The S&P 500's ability to withstand higher rates will therefore depend not only on the number of additional increases but also on how the economy and corporate profits respond to tighter financial conditions. Recent trading has shown that markets can absorb the prospect of further hikes when growth remains resilient, but renewed inflation pressure or a sharper slowdown could increase volatility.
