When interest rates are relatively low, so are lending costs to businesses and consumers. But when the Federal Reserve hikes the rates it charges banks to loan out money, some stock investors get worried. The concern is that a higher federal funds rate will lead to less liquidity in markets and dampen economic activity. 

A study of the long-term data, however, doesn't suggest a direct correlation between poor equity returns and Fed policy pivots to the upside. In fact, we find that equity returns in the U.S. have been positive on average following hikes in the fed funds rate.

A Deeper Look at the Data

The federal funds rate is the targeted interest rate set by the Federal Open Market Committee (FOMC) for banks and other depository institutions to lend money to each other, typically on an overnight basis. An increase in the Fed's targeted rate makes borrowing more expensive — on a short-term basis — and effectively lowers the available supply of money in the U.S. economy.

The FOMC holds eight regularly scheduled meetings a year but isn't required to change the target rate. Likewise, it can also decide on multiple revisions in the same month. It's made up of the Federal Reserve system's board of governors and reserve bank presidents from around the country. 

The chart below compares changes in the federal funds target rate for an extended period (1983-2021) to the all-cap Fama/French Total US Market Research Index. During these 38 years, rates went up in 70 months and fell in 67 months. (When the FOMC changed the target rate multiple times within the same month, we aggregated all changes by month.)

The key takeaway here: On average, U.S. equity market returns are reliably positive in months with increases in target rates. Also, it's probably worth noting that the average stock market return in those months was similar to the average return in months with decreases or no changes in target rates. Still, this might lead some people to ask: "What about the months after rate hikes?" In particular, this is a question that would seem to be worth exploring when the Fed is expected to increase the federal funds target rate multiple times. 

To look into this issue, we studied annualized domestic equity market returns following one or two consecutive monthly increases in the fed funds target rate as well as following months with no increase. (See chart below.) Using the same Fama/French total markets index and breaking results down by one-, three- and five-year periods, we see during these 38 years the U.S. stock market produced relatively strong longer-term performance on average regardless of activity at the Fed.

Even applying a filter of Fed rate hikes over shorter timeframes argues against trading equities based on such recent events. In the graphic below, we consider two distinct periods of increasing Fed Fund Rates policy for case studies: namely, 2004 through 2006 and 2016 through 2018. It shows that just as the Fed was embarking on raising rates in 2004, the U.S. market (as represented by the IFA SP 500 Index) went up 10.77%.

A year later, blue chip stocks rose nearly 5% (4.98%). In 2006, stocks were up on average by 15.72%. What about in the next go-around with rising interest rates? In 2016, the IFA SP 500 index returned 11.90%, followed by 21.77% in the next year. However, in the third year of this rate hiking period by the Fed, this domestic benchmark of blue chip stocks actually slid a bit, losing 4.42%. 

An Evidence-Based Conclusion

When looking at evidence over longer timeframes to give us a significant set of data, there doesn't seem to be a precise narrative pinning higher interest rates with a sell-off in stocks. "Do the rates set by the Fed matter to the market — absolutely," says Apollo Lupescu, a Dimensional Fund Advisors vice president. "It's one of the many many variables that drives the market."

After several studies over longer timeframes, Dimensional's researchers have reached a similar conclusion, he adds. In short, a period of rising interest rates "just doesn't appear to be a primary variable that can be directly linked," says Lupescu. "You just can't assume that if rates go up, stocks are going to go down — there's just not enough evidence to support such an assumption."

Still, it's not unusual during such periods for investors to hear and read dire prognostications that stocks are down for the count. Such a focus on the short-term direction of interest rates, notes Lupescu, represents an attempt to spoon-feed investors with "a really easy explanation that anybody can understand." In fact, he warns: "It's a lot more complicated than just a rising Fed Funds rate — it's one of the shortcuts to investing out there that's too simplistic and rather naive."

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