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When the Federal Reserve (Fed) raises interest rates, it’s viewed as a sign of strength for the U.S. economy and a signal that inflation will continue to rise in the coming months. A rate hike also impacts stock market investments by increasing the cost of borrowing money and favoring safer, fixed-income investments like bonds over riskier stocks. However, while raising interest rates is usually considered negative for stocks because it increases the cost of investing in them, historically speaking this has had little impact on long-term returns. In fact, many financial advisors view a rate hike as positive for their clients—especially those who are heavily invested in riskier areas like small company stocks or emerging markets ETFs—because it makes them less susceptible to downturns in those sectors.
What is the Fed and why does it matter?
The Federal Reserve System is the United States central banking institution. Its job is to oversee the economy, regulate banks, and influence the cost of borrowing money. Central banks play a critical part in managing the economy because they can alter interest rates, which can have a significant effect on economic expansion. In the U.S., the Fed is empowered to control the nation’s money supply by adjusting interest rates. The Fed funds rate, which is the rate banks charge each other to borrow or lend excess reserves overnight, can be increased or decreased to achieve this goal.
How Is a Fed Interest Rate Hike Consistent with an Improving Economy?
As the U.S. economy continues to strengthen and the unemployment rate falls, the Federal Reserve will likely continue to raise interest rates. While rising interest rates are often viewed as negative for stocks, it’s important to put this into context. In short, the Fed raises interest rates to slow economic growth in order to keep inflation in check. When inflation is higher than desired, the Fed steps in and raises interest rates to make borrowing money more expensive. This drives down demand and slows economic growth to control the rising cost of goods and services.
The short-term impact of a rate hike on stocks
The short-term impact of a Fed interest rate hike on stocks is negative because it raises the cost of borrowing money and makes risky stocks less attractive to investors. As interest rates increase, the cost of taking out stocks decreases. This is why many investors choose to sell stocks and buy bonds when interest rates are rising. Stocks have a higher risk of falling in value, while bonds are a steady source of income. Stocks generally decline in the short-term in response to a rate hike, but the rate hike itself has little correlation with long-term stock market returns.
Long-term impact of a rate hike on stocks
The long-term impact of a Fed interest rate hike on stocks is minimal. In fact, many financial advisors recommend investing in stocks even when interest rates are rising because stocks have historically produced a steady stream of income through dividends and stock buybacks. This is due to the fact that stocks are riskier when interest rates are rising. When rates are rising, investors are more likely to sell their risky stocks and invest their money in bonds. This drives the price of stocks down and makes them more attractive to investors. When rates are falling, on the other hand, investors are more likely to hold onto their stocks and wait for them to rise. This drives up the price of stocks and makes them more attractive to investors looking for growth.
The Potential Downsides of a Fed Interest Rate Hike for Stocks
While a Fed interest rate hike is generally viewed as positive for stocks, it can sometimes have a negative impact on certain industries. For example, stocks in utilities companies and telecom stocks tend to fall when rates rise. This is because these companies operate in a sector called the “fixed-income” sector, which offers steady but lower returns. When rates are rising, investors are more likely to sell these stocks and invest their money in areas like real estate, where returns are greater but riskier. Another potential risk of a Fed interest rate hike is that it can slow down economic growth and hurt the stock market overall. While this is a risk, history suggests it’s unlikely.
Final thoughts
A Fed interest rate hike is generally considered a positive sign for the economy. Higher interest rates, however, can negatively impact stocks in the short term by driving down demand and increasing the cost of borrowing money. While a Fed interest rate hike is viewed as a positive sign for stocks, it’s important to note that the impact of a rate hike on stocks is minimal when put into historical context. Over the long term, stocks have consistently outpaced Treasury bonds in both good and bad economic times.
