The Fed Just Raised Rates for the First Time in Three Years. History Says This Is What Comes Next.

The Federal Reserve raised interest rates rapidly in 2022 and 2023 in response to inflation rising to a multi-decade high. And ever since then, investors have mainly wondered how quickly rates would fall, and when we entered 2026, most didn't feel that the rate cuts were done yet.

However, after a significant increase in inflation this year, the Fed reversed course and tightened monetary policy. On Sept. 16, the Fed announced its first rate hike in three years, a 25-basis-point increase to a federal funds rate target range of 3.75%-4%. The move was small, but it marks the official start of a tightening cycle.

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What should investors expect? Here's what history says about stock market returns after the Fed starts tightening, and how you can adjust your portfolio for the new environment.

Why the Fed raised rates

The short answer is inflation. The Fed's statement accompanying the rate hike said inflation remains elevated and that the hike is intended to support a quicker return to the central bank's 2% inflation target. Chair Kevin Warsh said in his press conference that recent inflation data doesn't show significant improvement, so action was necessary.

What history says about the start of a tightening cycle

Here's the short version. The S&P 500 has historically been weak for the first few months after a tightening cycle begins, but recovers fairly quickly.

In fact, by the 12-month mark following the first hike of a cycle, the S&P 500 has historically been higher by an average of about 6.7%. Of course, the exact performance varies with each rate-hike cycle, but a key point is that the S&P 500 produced positive returns in every 12-month period following the start of a rate-hike cycle except one. If you're curious, the only exception was in 2022, when there was a fast and aggressive rate-hike cycle with several "triple rate hikes" to combat generationally high inflation.

In a nutshell, some initial weakness is normal and has historically been a buying opportunity, not the start of a long-tailed decline, even if the Fed continues to raise rates. What's more, in slow-paced rate hike cycles, the S&P 500 averaged a gain of 10.5% over the next 12 months. The Fed's expectation right now is for one more hike this year and no rate changes this year, so it's looking like a slow cycle so far.

There's one big distinction that makes this tightening cycle a bit different than most, and it's the fact that rates weren't very low to begin with. And not just the federal funds rate. We're starting this tightening cycle with the long end of the yield curve well above 5%. The 10-year Treasury yield was already at a 19-year high before the Fed's action.

How to adjust your portfolio

To be sure, investors with a long-term focus don't need to make any drastic changes because the Fed raised rates. But if your portfolio was designed with expected rate cuts in mind, it could be worth taking a closer look. For example, stocks that rely on cheap capital for their growth ambitions could underperform in a tightening cycle. It's also worth noting that risk-free investments like Treasuries, CDs, and high-yield savings accounts pay significantly more than they did even a few months ago, so the opportunity cost of keeping some dry powder on the sidelines isn't terribly high right now.

Looking ahead, the base case is for one more rate hike this year, with most experts expecting it in December. There's no guarantee that history will repeat itself, and every rate-hiking cycle is different, but it's important to keep in mind that rate hikes aren't necessarily the negative near-term catalyst that many think they are.

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