Will the Federal Reserve Trigger a Bear Market? History Has Good and Bad News for Investors

After months of foot-dragging, the Federal Reserve finally hiked its benchmark interest rate last week. Many economists and Fed watchers had expected that rate hike earlier, perhaps back in July, but Fed Chair Kevin Warsh said he and his colleagues waited a bit longer than expected to better assess the underlying causes of persistently elevated inflation.

Fair enough. But the Fed's move on rates doesn't look like a one-and-done hike. I wrote an article shortly after the Fed announced its latest policy change, arguing that all indicators -- the Fed's own projections and verbiage, as well as bond and futures market pricing -- suggest that last week's hike is likely the first of several.

I won't rehash that article here, other than to say that the fed funds futures market is pricing in two to three more quarter-point hikes by the end of 2027. So, it's probably not a single hike, and more likely a series of hikes.

That raises a critical question for investors: Will that hiking cycle trigger a bear market?

Well, the research here is mixed. Clearly, higher interest rates increase borrowing costs for companies, which can squeeze their profit margins and earnings. In addition, higher interest rates make borrowing more expensive for consumers, so they would be less likely to purchase items that require loans -- like cars and homes -- when rates are rising. Those are definitely bearish outcomes from a rate-hiking cycle.

Rate-hiking cycles can result in recessions

And many, even most, past tightening cycles have led to economic contractions, which are certainly bearish for the stock market. This Fed, like past ones, will certainly aim for a so-called "soft landing," in which it tightens policy to a neutral interest rate to control inflation while avoiding pushing the economy into recession. That has been done before, and much depends on the context. That is, how much tightening is needed, how robust the economy is, and so on.

Should a recession occur, history says a bear market is also much more likely.

Image source: Getty Images.

But much depends on the timing, too. Recessions triggered by rate tightening cycles typically don't begin until more than a year after the first Fed rate increase. And while stocks have typically traded lower in the first three months after a Fed rate increase, markets often adapt to rising rates, and stocks can trade higher over the next year.

The current situation, however, is an odd one. Bond yields have been rising all year due to a sell-off in the bond market. And many borrowing rates are directly tied to yields, not to the very short-term rates the Fed dials up and down.

Also, much of the inflation we've been experiencing is due to the war in the Persian Gulf and the higher oil prices it has caused. The Fed can't do a lot about that.

So, what's the final answer? Well, the U.S. economy is very strong right now, with unemployment low and growth estimated at 5.1% annually, according to the Atlanta Fed. Plus, corporate earnings last quarter were robust and are expected to remain that way through the end of the year. That makes the economy and the stock market much more resilient in the face of the Fed's rate-hiking cycle.

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