Surprisingly Benign: How Stocks Respond to Hikes in Fed Funds Rate

On May 4, the US Federal Reserve increased the target federal funds rate1 by 50 basis points as part of what the central bank said will be a series of rate increases to combat soaring inflation in the US. Some investors may worry that rising interest rates will decrease equity valuations and therefore lead to relatively poor equity market performance. However, history offers good news: Equity returns in the US have been positive on average following hikes in the fed funds rate.

We study the relation between US equity returns, measured by the Fama/French Total US Market Research Index, and changes in the federal fund’s target rate from 1983 to 2021. Over this period of 468 months, rates increased in 70 months and decreased in 67 months. Exhibit 1 presents the average monthly returns of US equities in months when there is an increase, decrease, or no change in the target rate. On average, US equity market returns are reliably positive in months with increases in target rates.2 Moreover, the average stock market return in those months is similar to the average return in months with decreases or no changes in target rates.

What about the months after rate hikes? This question may be of particular interest when the Fed is expected to increase the federal funds target rate multiple times. Exhibit 2 presents annualized US equity market returns over the one-, three-, and fve-year periods following one or two consecutive monthly increases in the fed funds target rate, as well as following months with no increase. In reassuring news for investors concerned with the
current environment of increasing rates, the US equity market has delivered strong longer-term performance on average regardless of activity at the Fed.