Key facts
- Markets are pricing in a high probability of Federal Reserve rate hikes in the remaining months of 2026.
- AI spending is fueling outsized earnings growth, which could counterbalance rate hike impacts.
- Inflation has moderated from its peak, potentially allowing the Fed to hike rates slowly.
- Historically, slow Fed tightening cycles have seen the S&P 500 rise, while quick cycles have led to stock drops.
- The current inflation level is unlikely to necessitate the same magnitude of rate hikes seen in 2022.
Investors are closely watching the Federal Reserve's potential interest rate hikes, with markets pricing in a high likelihood of increases in the coming months. As of Thursday afternoon, the CME FedWatch tool indicated a 71.8% chance of a rate hike at the September meeting and a 63.5% probability of at least two hikes by the December meeting. The Fed uses short-term interest rates as a tool to manage economic activity, aiming to control inflation or stimulate job growth. With inflation remaining sticky at 3.4% year-over-year in July, the expectation is that the central bank will raise rates to curb rising consumer prices.
Historically, periods of rising interest rates have been challenging for the stock market. Data from LPL Financial shows that since 1994, the S&P 500 has experienced negative returns in the six months following the initial rate increase in a hiking cycle. The aggressive rate hikes in 2022, which pushed the fed funds rate from near zero to over 5%, led to a 20% decline in the S&P 500 that year.
However, some market professionals suggest that this cycle may differ. Whitney Stewart, a client portfolio manager at Sterling Capital Management, pointed to significant AI spending by hyperscalers as a driver of strong earnings growth, with expectations for double-digit growth in S&P 500 earnings for 2027. Stewart believes this AI-fueled growth could counterbalance the dampening effects of rate hikes.
LPL Financial drew a parallel to 1997, when the S&P 500 continued its rally despite Fed rate hikes, buoyed by optimism surrounding the internet. Additionally, while inflation remains elevated, it has shown signs of moderation, down from a peak of 4.2% in May. This moderation could allow the Fed to implement rate hikes at a slower pace, a factor that historically benefits stocks.
Kevin Gordon, head of macro research and strategy at Charles Schwab, noted that in slow tightening cycles, the S&P 500 has averaged a 10.5% gain in the following year, whereas quick tightening cycles have seen an average drop of 3.6%. Gordon suggested that if the Fed adopts an "elevator response"—hiking rates in small increments, possibly at alternate meetings—stocks may be better able to absorb the changes.
Mike Reynolds, vice president of investment strategy at Glenmede, also commented on the quantity of hikes, noting that with inflation currently much lower than the over 9% seen in 2022, the Fed may not need to implement as many hikes. Reynolds stated that while stocks might reprice after a hike, a large, sustained drawdown similar to 2022 is not his base case.