Why the Fed has less sway over the stock market than investors think

MW Why the Fed has less sway over the stock market than investors think

By Mark Hulbert

Interest-rate moves have surprisingly little market-forecasting ability

Stock investors closely watch the Federal Reserve and its Chair Jerome Powell (pictured), but other factors are better predictors of the market's direction.

Investors are making too big a deal over whether interest rates will be cut at the December meeting of the Federal Reserve's interest-rate-setting committee. Interest rates have surprisingly little ability to forecast the stock market's direction.

To show this, I analyzed the 10-year Treasury BX:TMUBMUSD10Y yield (or equivalent) since 1871; for each month since, I calculated the difference between it and the S&P 500's SPX earnings yield (the inverse of its P/E). To the extent interest rates have an impact on the stock market, we'd expect the S&P 500 to perform worse when the 10-year yield is above the market's earnings yield - and vice versa. But that isn't what the data show.

Consider the chart above, which plots the relationship between the stock market's total real return and the so-called Fed Model. That model is positive when the 10-year Treasury yield is below the stock market's earnings yield, and negative when it is the reverse. Notice not only that there is very little difference in the average returns, but that in the case of subsequent one-year and five-year returns, the stock market has actually performed better when the Fed Model was negative.

Why interest rates have a relatively small impact

The primary reason why interest rates have had a surprisingly small impact on the stock market is that interest rates are correlated with inflation - and stocks historically have produced a greater nominal return when inflation is higher. This is why, on average, the stock market has produced a higher return over the long term - before adjusting for inflation - when interest rates are higher.

After adjusting for inflation, this higher average nominal return largely disappears. This explains why the chart shows that the Fed Model has little to no impact on the stock market's return, since the chart focuses on real returns, rather than nominal ones.

Ultimately, investors are guilty of "inflation Illusion" when they fail to recognize these interconnections between interest rates, inflation and the stock market. While investors are not wrong in believing that higher interest rates translate to future years' earnings having a lower present value, that's only half the story. The other half is that nominal corporate earnings tend to grow faster when inflation (and hence interest rates) is higher.

The bottom line? The stock market could suffer in the coming days and weeks. But you should focus on factors besides interest rates when assessing whether it will do so - such as the stock market's extreme overvaluation and Wall Street's near-record level of optimism.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com

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-Mark Hulbert

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November 18, 2025 07:45 ET (12:45 GMT)

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