Interest Rates May Do Something Last Seen in 2022. The Stock Market Will Make a Big Move Afterward if History Repeats.

Year to date, the S&P 500 (SNPINDEX: ^GSPC) and Nasdaq Composite (NASDAQINDEX: ^IXIC) have added 11% and 13%, respectively. The driving force behind that upside has been strong corporate financial results.

However, the Federal Reserve has become increasingly hawkish in recent months because of the impact of the Iran conflict. Half the members on the rate-setting committee now expect at least one interest rate increase this year. That would mark the beginning of a new tightening cycle (i.e., a period where interest rates are rising).

Historically, the onset of a tightening cycle has frequently coincided with steep declines in the stock market. In fact, the S&P 500 and Nasdaq dropped into correction territory when the Fed initiated its last tightening cycle in March 2022. Here's what investors should know.

Image source: Getty Images.

The market expects the Federal Reserve to raise interest rates this year

In March, the Iran conflict effectively closed the Strait of Hormuz, a critical chokepoint in the Persian Gulf. About 20 million barrels of oil pass through the strait each day, which is equivalent to roughly 20% of petroleum liquids consumed worldwide. The International Energy Agency called it the largest oil supply disruption in history.

Oil prices initially soared to a four-year high, then dropped sharply after the U.S. and Iran announced a peace deal in June. But WTI futures prices (a U.S. benchmark for oil) started rising again last week, when Iranian attacks on commercial oil tankers prompted President Trump to call off the fragile ceasefire.

Meanwhile, CPI inflation soared to 4.1% in May, the highest reading since April 2023. Of course, inflation will probably cool in the months ahead because oil prices remain well below their April peak, but the market still expects the Federal Reserve to raise its benchmark interest rate twice in the next year.

The market is pricing in one quarter-point rate increase in September, followed by a second quarter-point increase in March 2027, per CME Group's FedWatch tool. That aligns with the latest projections from the Federal Open Market Committee (FOMC). Half of FOMC officials said at the June meeting that at least one quarter-point rate increase was likely this year, up from zero at the March meeting.

A rate-raising cycle has often coincided with stock market corrections

Warren Buffett believes interest rates (especially those on government bonds) are the most important variable that affects stock market valuations. "These act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull," he wrote in 1999.

Since 1999, the Federal Reserve has started four tightening cycles, meaning it has pivoted from interest rate cuts to interest rate increases on four occasions. The following chart shows the maximum drawdown in the S&P 500 and Nasdaq Composite during the three-month period following the first increase in each cycle.

Data sources: Federal Reserve, YCharts. The chart shows the peak decline in the S&P 500 and Nasdaq Composite during the three-month period following the Fed's first rate increase in a tightening cycle.

Following the first interest rate increase in a tightening cycle, the S&P 500 and Nasdaq have fallen by an average of 10% and 15%, respectively, at some point in the next three months. In other words, both major stock indexes have typically dropped into market correction territory when the Fed has pivoted from rate cuts to rate increases.

Of course, that doesn't mean the S&P 500 and Nasdaq will suffer a correction if the Fed initiates a new tightening cycle in 2026, but investors should certainly be prepared for that outcome. When the Fed increases its benchmark interest rate, it pushes other rates higher across the economy. And the higher rates climb, the less attractive stocks look relative to bonds.

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.