Why Rate Hikes Might Not Crash the Market in 2026

When the Fed raises interest rates, it can slow inflation and economic growth, and also weigh down the stock market. The Fed raised interest rates last week, the first time it's done so since 2023. But when it actually began raising rates in the previous year to slow down inflation, the results were devastating: the S&P 500 (SNPINDEX:^GSPC) fell by more than 19%.

This time around, an increase in interest rates might not end up crashing the stock market. Instead, it might give investors added confidence.

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Why interest rate hikes may help the market this time around

The Fed raised interest rates last week, but there isn't a panic in the markets. Instead, the S&P 500 has been rising higher since then. There were concerns that new Fed Chair Kevin Warsh might be reluctant to raise rates or perhaps even cut them, in an effort to appease the U.S. president.

By raising interest rates, however, Warsh showed his commitment to controlling inflation, and in doing so, gave investors confidence in the Fed's ability to remain independent and do what's best for the overall economy. Even with there potentially being another rate hike ahead this year, the market doesn't appear to be worried. The greater risk may have very well been if the Fed didn't raise rates, with inflation still not being anywhere near its 2% target -- currently it's at 3.4%.

Investor confidence can be key to the market continuing to rise in value. While interest rates are up and now in the 3.75%-4.00% range, they're still far lower than they were three years ago, when they were north of 5%.

Remaining invested is still a good idea, but investors shouldn't ignore valuations

The stock market may continue rallying this year, but that doesn't mean that all stocks are safe buys right now. There are many overvalued stocks trading at sky-high multiples that possess significant downside risk. A correction or market crash could occur quickly and without notice. While conditions still look strong today, that doesn't mean there isn't risk or uncertainty in the markets.

For investors, it may still be a good idea to consider reevaluating their holdings to ensure they aren't taking on too much risk. Highly priced stocks could be vulnerable to corrections and declines, even if there isn't a full-blown crash. Investing in diversified exchange-traded funds that track the S&P 500 or holding value stocks can be effective ways to reduce some risk.

David Jagielski, CPA has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.