Wall Street Expects Bad News From the Federal Reserve This Week. History Says a Stock Market Correction May Follow.

The U.S. stock market is having another fantastic year, driven by massive spending on artificial intelligence infrastructure. Year to date, the broad-based S&P 500 (SNPINDEX:^GSPC) has added 12%, the technology-heavy Nasdaq Composite (NASDAQINDEX:^IXIC) has advanced 13%, and the blue chip Dow Jones Industrial Average (DJINDICES:^DJI) has added 9%.

However, Wall Street expects the Federal Reserve to raise interest rates this week, potentially marking the start of a new tightening cycle. Historically, the first rate hike in a new tightening cycle has often correlated with stock market corrections. Here are the important details.

Image source: Official Federal Reserve Photo.

Wall Street expects the Federal Reserve to raise interest rates this week

CME Group's FedWatch tool analyzes the prices of futures contracts tied to the federal funds rate to determine the market-implied probability of future interest rate changes. In other words, it shows what the futures market is pricing in concerning the Federal Open Market Committee's (FOMC) future interest rate decisions.

The FedWatch tool currently points to a quarter-point rate hike as the most likely outcome from the FOMC meeting ending on Sept. 16. Specifically, there is an 87% chance the target range for the federal funds rate will increase to 3.75% to 4%, up from 3.5% to 3.75% today. The market also expects another quarter-point rate hike at the December meeting.

The market expects higher interest rates because inflation has stayed above the Federal Reserve's 2% target since February 2021, meaning the central bank has failed to achieve price stability for 66 straight months. The responsibility for "sustained, elevated inflation sits squarely with the central bank," said Fed Chair Kevin Warsh in August.

Historically, new rate-hike cycles have often preceded stock market corrections

New tightening cycles are relatively rare. In fact, the Federal Reserve has only initiated three rate-hike cycles in the last 25 years. After the first hike in each cycle, the S&P 500, Nasdaq Composite, and Dow Jones have, on average, suffered double-digit losses at some point in the next three months, as shown in the chart below.

Data source: Federal Reserve, YCharts. The chart shows the maximum drop in the S&P 500, Nasdaq Composite, and Dow Jones Industrial Average during the three-month period after the first interest rate hike in a tightening cycle.

As shown above, all three major U.S. stock market indexes have, on average, entered stock market correction territory within three months of the first rate hike in a new tightening cycle. However, past performance is no guarantee of future returns. Many U.S. companies have delivered stellar financial results this year.

In the second quarter, S&P 500 companies reported revenue growth of 15%, the fastest pace since 2021. Even more impressive, S&P 500 earnings increased 31% (excluding unrealized gains), the fastest growth outside of a post-recession recovery since 1992, according to Bloomberg Intelligence. Earnings have been especially strong in the technology sector due to the artificial intelligence boom.

Looking ahead, continued earnings growth could provide a cushion for stocks if the Federal Reserve starts raising interest rates. Strong business fundamentals may help offset the pressure from higher borrowing costs and tighter financial conditions.

However, if the major indexes do suffer a correction, history says investors should treat the dip as a buying opportunity. The major indexes have recovered from every past drawdown, and there is no reason to expect a different outcome in the future.

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.