What do Fed rate hikes mean for the stock market? Yesterday, the U.S. Federal Reserve announced it would be raising interest rates for the first time since December 2018. The Fed agreed to raise interest rates, or the federal funds rate, by 0.25% or 25 basis points.
As inflation rises, raising the federal funds rate is key to combatting higher item prices. After the increase, the federal funds rate will fall between 0.25% and 0.50%. So, how will the Fed rate hikes affect the stock market?
Here’s what investors should know about rate hikes moving forward.
What Do Fed Rate Hikes Mean for the Stock Market?
Currently, the Fed estimates that it will raise rates six more times this year. This would mean that the federal funds rate would increase to 1.9% by the end of 2022. What’s more, the Fed foresees raising rates another three times in 2023. There will be no additional hikes in 2024.
In terms of its looming $9 trillion balance sheet, the Fed explained the following:
“[T]he Committee expects to begin reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities at a coming meeting.”
Increased interest rates are generally seen as having a negative effect towards stocks. This is because many valuation models incorporate the discounted cash flow (DCF) model. The DCF model seeks to value a stock by discounting a company’s estimated future cash flows back to the present value, or today. A key input in the model is the discount rate, which is included in the denominator of the model. Meanwhile, cash flows are included in the numerator of the model.
Interest rates directly affect the discount rate. So, if interest rates increase, so will the discount rate. As a result, a higher discount rate will lessen the value of future cash flows when discounted back to the present value.
The cost to borrow money from financial institutions will also increase. This can potentially stifle company growth, as taking on debt will become more expensive. However, there is still a silver lining with the latest rate hike.
Market Returns Are Positive One Year After First Rate Hike
What’s the upside with the latest rate hike?
Well, according to an infographic from Bloomberg, the S&P 500 has handed out positive returns 100% of the time following a year after the first rate hike. Furthermore, the average return for the S&P 500 one year following a rate hike is a whopping 10.8%. However, this return may be positively skewed by the rate hikes of 1988 and 1997, which saw returns of 20.7% and 39.6%, respectively. Factoring out 1988 and 1997, the average return would be 4.38%.
On the date of publication, Eddie Pan did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
