Driven by massive investments in artificial intelligence infrastructure, U.S. equities have delivered another stellar performance this year.
Year-to-date, the broad-based S&P 500 is up 12%, the tech-heavy Nasdaq Composite has climbed 13%, and the blue-chip Dow Jones Industrial Average has gained 9%. However, Wall Street expects the Federal Reserve to raise interest rates this week, potentially kicking off a new tightening cycle. Historically, the first rate hike of a new tightening cycle has often coincided with a stock market pullback. Here are the key details.
Wall Street expects a Fed rate hike this week
According to the CME FedWatch Tool, which gauges market-implied probabilities of future rate changes based on federal funds futures contract prices, the most likely outcome of the September 16 FOMC meeting is a 25-basis-point hike. Specifically, the probability of the federal funds target range moving from 3.5%-3.75% to 3.75%-4% sits at 87%. Markets are also pricing in another 25-basis-point increase at the December meeting.
The expectation for higher rates stems from inflation remaining above the Fed's 2% target since February 2021, meaning the central bank has now missed its price stability goal for 66 consecutive months. Fed Chair Kevin Warsh stated in August that "the responsibility for persistently elevated inflation rests entirely with the central bank."
Equities tend to retreat after a new rate hike cycle begins
New monetary tightening cycles are uncommon, with the Fed having initiated only three over the past 25 years. Data indicates that within three months following the first hike of each cycle, the S&P 500, Nasdaq, and Dow have all averaged double-digit maximum drawdowns.
Table: Cycle first hike dates and average maximum drawdowns—June 2004: S&P 500 -7%, Nasdaq -14%, Dow -6%; December 2015: S&P 500 -10%, Nasdaq -15%, Dow -10%; March 2022: S&P 500 -17%, Nasdaq -22%, Dow -13%; Averages: S&P 500 -11%, Nasdaq -17%, Dow -10%. Data sources: Federal Reserve, YCharts; the metric is the maximum decline for each index within three months after the first hike of a tightening cycle.
As shown, historically, all three major U.S. indices enter correction territory within three months after the first hike of a new tightening cycle on average. Yet, past performance does not guarantee future returns. This year, many U.S. firms have delivered impressive earnings, with S&P 500 second-quarter revenue up 15% year-over-year—the fastest pace since 2021—according to Bloomberg Intelligence. More notably, excluding unrealized gains and losses, S&P 500 earnings surged 31%, the strongest performance outside of post-recession recovery phases since 1992. Technology sector earnings have been particularly robust, fueled by the AI boom.
Looking ahead, if the Fed begins raising rates, sustained earnings growth could provide a cushion for equities, with solid corporate fundamentals potentially offsetting pressures from higher borrowing costs and tighter financial conditions. However, should the major indices indeed pull back, historical experience suggests investors should maintain a long-term perspective. Every prior drawdown has eventually been recovered, offering no reason to expect a different outcome this time.
Comments