The Federal Reserve recently raised its benchmark interest rate for the first time in more than three years, marking the beginning of a new tightening cycle.
President Trump’s policies, especially tariffs and military action in Iran, have contributed to the inflation that made that rate hike necessary.
Historically, the S&P 500 and Nasdaq Composite have frequently dropped into correction territory following the first rate hike in a new tightening cycle.
Since 1928, the S&P 500 (SNPINDEX:^GSPC) has declined in September 55% of the time, losing an average of 1.1%, according to Yardeni Research. Both metrics make September the worst month of the year for the U.S. stock market.
Experts quibble over the cause of the so-called "September Effect," with some attributing the losses to a self-fulfilling prophecy and others citing seasonal factors, such as portfolio rebalancing and the end of summer vacations.
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This year, the S&P 500 traded sideways through the first three weeks of September, but investors recently got bad news about President Trump's economy, hinting at a potential stock market correction.
President Donald J. Trump speaks at a White House press briefing. Image source: Official White House Photo.
President Trump has made it no secret that he wants the Federal Reserve to lower interest rates. Ahead of the Fed meeting earlier this month, he even threatened to stop trading with some countries. "Lower the rate or I'll stop trading with countries with which we have a deficit," he wrote on social media. When asked about the post, Trump said the U.S. should have "the lowest interest rate in the world."
However, the Federal Open Market Committee (FOMC) did the exact opposite this month. Rather than cut interest rates, officials voted unanimously to raise the target range on the federal funds rate, marking the first rate hike in more than three years. The vast majority of officials also signaled another quarter-point rate hike in the remaining months of 2026.
Of course, President Trump was not pleased with the decision, but his own policies have contributed to the inflationary pressures the Fed is trying to stamp out. Several decisions during his second term have directly or indirectly led to price increases, most notably his sweeping tariffs and military action in Iran.
To elaborate, tariffs have added about 0.4 percentage points to core inflation, according to research from the Federal Reserve Banks of St. Louis and Minneapolis. Meanwhile, the price per gallon of regular gasoline has risen 40% over the past year due to the disruptions in global oil supplies caused by the ongoing conflict in the Middle East.
So what? New rate-hike cycles have frequently coincided with stock market corrections. The Fed has initiated three rate-hike cycles in the last 25 years, and following the first hike in each cycle, the S&P 500 dropped by an average of 11% at some point over the next three months. The Nasdaq Composite (NASDAQINDEX:^IXIC) declined by an average of 17% over the same periods.
U.S. Treasury bond yields have surged in recent weeks, driven by concerns about inflation, the national debt, and expectations for higher interest rates. Heavy corporate borrowing to fund artificial intelligence (AI) projects has also put upward pressure on Treasury yields by creating competition for investor capital.
Fund managers surveyed by Bank of America see rising yields as the single greatest risk to the stock market. Businesses and consumers tend to spend less money when borrowing costs rise, creating a headwind to corporate earnings growth. That tends to pull the major indexes down because stocks are generally valued based on earnings.
Additionally, bonds become increasingly attractive relative to stocks as yields rise, forcing investors to ask themselves whether it's worth owning risky stocks when risk-free Treasury bonds offer relatively attractive returns. The odds that investors move capital from stocks to bonds increase as yields rise.
It's hard to know exactly where that line is, but we may have crossed it already. The 10-year Treasury bond yielded 5.01% when the market closed on Friday, Sept. 18, marking the largest payout since July 2007. What happened last time? The S&P 500 and Nasdaq Composite suffered bear markets, with both indexes plunging more than 20% during the next year.
Here's the big picture: Not only did the Federal Reserve recently raise its benchmark rate, but elevated bond yields also suggest that investors expect interest rates to climb higher. History says those headwinds could trigger a stock market correction, so investors should be prepared for a drawdown.
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