Interest Rates Are Likely to Rise This Year. Here's What That Could Mean for the S&P 500

With Kevin Warsh's first Fed meeting in the books, there's a bit more clarity about what the future may hold for interest rates and Fed policy. While some investors feared Warsh might lower interest rates quickly simply to appease the president, that hasn't happened.

Not only have rate cuts not occurred, but Warsh is also committed to getting inflation back to 2% (currently it's at more than 4%), suggesting the Fed may once again raise interest rates in the near future, as doing so could help bring inflation down.

What does this mean for the S&P 500 (SNPINDEX: ^GSPC) and the overall stock market?

Image source: Getty Images.

There may be rate hikes, but they likely won't be as significant as they have been in the past

The last time the Fed started hiking rates was in 2022, which was again to fight inflation. That year featured several rate increases, and it was a particularly disastrous one for the stock market, as the S&P 500 crashed by more than 19%. But even if interest rates rise this year, any hikes may not be as significant as they were back then.

Back in 2022, the Fed funds rate was near zero compared with a range of 3.50% to 3.75% today. Although interest rates have come down in the past couple of years, they aren't nearly as low as they were in 2022. Raising interest rates aggressively this time around could wreak havoc on the economy, as it would raise borrowing costs and mortgage rates for consumers already struggling with challenging economic conditions. That is why I don't expect that to happen.

The S&P 500 may still be overdue for a slowdown

After three years of robust gains in excess of its long-run average of 10%, the S&P 500 may be well overdue for a slowdown, regardless of what happens with interest rates. Not only is it at record levels, but the index is now up around 93% since 2023. If it were growing at about 10% per year, then after three years, its gains would be around 33%; it's been punching well above its weight for a while.

^SPX data by YCharts

Not only is the S&P 500 richly valued these days, but it's also heavily dependent on the continual growth of tech stocks, which are propping it up. Even if a full-blown crash may not be likely, investors should brace for the possibility of at least a modest correction.

If you're a long-term investor, you may still want to stay the course and remain invested in S&P 500 index funds. But if you are nearing retirement or may need to access your money in the not-too-distant future, you may want to consider safer investments, such as funds that track dividend stocks, in order to reduce some of your risk in the market today.

David Jagielski, CPA has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.