Stock Market Investors Got a Final Warning From Fed Chair Jerome Powell. History Says This Will Happen Next.

The S&P 500 (SNPINDEX: ^GSPC) and Nasdaq Composite (NASDAQINDEX: ^IXIC) dropped sharply when President Trump launched military operations in Iran earlier this year. Investors worried that a protracted conflict would upend the economy by raising oil prices.

Somewhat surprisingly, the S&P 500 and Nasdaq Composite have already recouped their losses and rocketed to new highs. In fact, the S&P 500 has moved higher in eight straight weeks, its longest winning streak since December 2023.

But the rebound may have been premature. Oil prices are still 60% higher than where they started the year, and U.S.-Iran tensions remain elevated.

To that end, during his final press conference as Federal Reserve Chairman, Jerome Powell warned that the Middle East conflict had clouded the economic outlook. Interest rate cuts, once considered a given in 2026, are now highly unlikely. Instead, soaring Treasury yields hint at interest rate hikes and a steep decline in the stock market.

Former Federal Reserve Chairman Jerome Powell makes remarks at an FOMC press conference. Image source: Official Federal Reserve Photo.

Jerome Powell finished his term as Federal Reserve chairman with an urgent warning

The Federal Open Market Committee (FOMC), the Federal Reserve branch responsible for setting monetary policy, left interest rates unchanged for the third straight time following a two-day meeting in April. Afterward, Jerome Powell hosted his final press conference as Fed chairman, and he passed along an urgent warning.

"The economic outlook remains highly uncertain, and the conflict in the Middle East has added to this uncertainty," Powell said. "In the near term, higher energy prices will push up overall inflation. Beyond that, the scope and duration of potential effects on the economy remain unclear." Powell also ruled out the possibility of rate cuts for the foreseeable future.

Why? The combination of President Trump's tariffs and high oil prices tied to the Iran conflict has already pushed inflation to a multiyear high. CPI inflation increased to 3.8% in April 2026, the highest reading since April 2023. However, high energy prices now threaten to bleed into other areas of the economy by raising production and logistics costs.

PPI inflation (which tracks prices at the producer level) rocketed to 6% in April, the highest level since 2022. That is bad news for the economy because producers pass costs along to consumers, meaning changes in PPI inflation tend to foreshadow changes in CPI inflation. Indeed, a forecasting tool from the Federal Reserve Bank of Cleveland currently shows CPI inflation trending toward 6.8% in the second quarter.

High inflation might force the Federal Reserve to raise interest rates

Investors entered the year expecting the Federal Reserve to cut its benchmark interest rate by at least a half-percentage point by December 2026, but the odds of that happening have essentially fallen to zero because inflation has risen meaningfully. Traders now expect at least one quarter-point rate hike in the remaining months of the year, according to CME Group's FedWatch tool.

Higher interest rates are usually bad news for the stock market. Corporate earnings tend to grow more slowly because elevated borrowing costs limit their ability to invest in expansion and stifle consumer spending on interest-sensitive goods and services. Beyond that, higher interest rates make bonds look more attractive, which tends to pull money away from the stock market.

Indeed, the expectation that the Fed will raise interest rates pushed the yield on the 30-year Treasury bond to 5.18% in May 2026, the highest level since July 2007. The last time 30-year Treasuries paid that much, the S&P 500 fell 20% and the Nasdaq Composite dropped 17% during the next year. High yields force investors to ask: Why buy risky stocks when risk-free bonds offer reasonable returns?

Here's the bottom line: Jerome Powell labeled the economic outlook as "highly uncertain" due to inflationary pressure created by President Trump's decisions to impose tariffs and take military action in Iran. In turn, traders' expectations regarding interest rates have flip-flopped, and economic uncertainty has pushed bond yields higher. That leaves the stock market vulnerable to a drawdown, especially if the U.S.-Iran conflict continues much longer.

Trevor Jennewine has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends CME Group. The Motley Fool has a disclosure policy.