Will the Stock Market Crash if the Federal Reserve Raises Interest Rates? Soaring Bond Yields Portend Trouble.

On Friday, June 5, the S&P 500 (SNPINDEX: ^GSPC) retreated 2.6% and the Nasdaq Composite (NASDAQINDEX: ^IXIC) dropped 4.1% following an unexpectedly strong payroll report. Jobs growth has now exceeded 100,000 in three straight months, something that last happened in early 2024.

The stock market interpreted that as bad news because inflation recently hit a multiyear high, which means the probability of interest rate cuts is essentially zero. In fact, investors now expect the Federal Reserve to raise rates, and the pivot to rate hikes has historically caused stocks to drop.

But will the stock market crash if the Fed raises rates? Here's what investors should know.

Image source: Getty Images.

Investors think the Federal Reserve will raise rates by a half percentage point in the next 15 months

In December, CME Group's FedWatch tool -- which calculates the probability of different interest rate levels based on futures contract prices -- signaled two quarter-point rate cuts as the most likely outcome in 2026. But the economic backdrop is much different today, and investors now expect two quarter-point rate hikes by September 2027.

What changed? The labor market looks more resilient. The U.S. economy added just 116,000 jobs last year as businesses navigated an uncertain trade environment. That was the slowest pace of hiring since the COVID-19 pandemic in 2020. But the economy has already added 569,000 jobs this year.

"What we're seeing here is the catch-up from last year where employers were on pause," Wells Fargo senior economist Sarah House explained to The Wall Street Journal. She added, "Employers have a better sense of the growth backdrop" because uncertainty surrounding President Donald Trump's tariffs has dissipated to some degree.

Meanwhile, inflation has accelerated since Trump authorized military operations in Iran. The Consumer Price Index (CPI) recorded a year-on-year increase of 3.8% in April, the highest reading since May 2023. And CPI inflation probably topped 4% in May, though the official number won't be published until June 10.

So what? The Federal Reserve sets monetary policy with two objectives in mind: stable prices and maximum employment. With the jobs market looking less fragile, the Fed has more freedom to raise interest rates without fear of triggering a recession.

History says the stock market will drop if the Federal Reserve pivots to interest rate hikes

The Federal Reserve has initiated four rate-hiking cycles since 1999, and the major stock market indexes have typically declined over the next three months, as shown in the chart below.

Data source: Federal Reserve, YCharts. The chart shows how the S&P 500 and Nasdaq Composite performed over the three-month period following the first rate hike in a tightening cycle.

Since 1999, the S&P 500 and Nasdaq Composite have declined by 7% and 8%, respectively, during the three-month period following the first hike in a tightening cycle (i.e., a period where the Federal Reserve is raising interest rates).

Higher interest rates tend to bring the stock market down because higher borrowing costs suppress spending and raise interest expenses, both of which cut into corporate profits. That puts downward pressure on the market because stock prices are tied to corporate profits.

Higher interest rates also make bonds look more attractive. The mere prospect of rate hikes pushed the yield on 30-year Treasury bonds to 5.18% in May, a level last seen in July 2007. The last time 30-year Treasuries paid that much, the S&P 500 and Nasdaq Composite fell 21% and 18%, respectively, over the next year.

Here's the bottom line: Higher interest rates have often caused stocks to fall, but the losses have generally been too mild to qualify as stock market crashes. However, the recent spike in Treasury yields suggests investors are especially nervous this time, perhaps because the Iran conflict has led to the largest oil supply disruption in history.

If the conflict endures long enough to cause a substantial increase in core inflation (which excludes volatile food and energy prices) -- in other words, if elevated energy prices bleed into other goods and services by raising production and transportation costs -- the Fed's response may be particularly aggressive. That could cause the stock market to crash.

Wells Fargo is an advertising partner of Motley Fool Money. 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.