Investors Just Got Bad News From the Federal Reserve. Here's What History Says Comes Next.

Up to this point, the market seems to be getting more comfortable with the idea of higher interest rates. The Fed has thus far only hiked rates one time, but the futures market is currently pricing in three more quarter-point increases by mid-2027.

Throughout 2026, the bond market has been volatile, but long-term yields are starting to stabilize, and the S&P 500 (SNPINDEX: ^GSPC) remains near all-time highs thanks to artificial intelligence (AI)-fueled earnings growth.

Interest rate increases, however, take a while to filter down through the economy. A single quarter-point hike won't be a game changer, and it could take months for its financial impact to be fully felt. The biggest risk is that the Fed keeps increasing rates and keeps them higher for longer.

Unfortunately, according to the latest Fed meeting minutes, that's what the central bank currently has planned. And because of the long lag of rate increases to show up in corporate bottom lines, the consequences could hit long after Wall Street has stopped worrying about it.

Image source: Getty Images.

History says the bigger risk is future hikes

Investors generally assume that higher rates lead to lower stock prices. In isolation, that's usually true. But reality can be more nuanced.

Right now, the pressure of higher interest rates is mostly being offset by expectations for big earnings growth over the next several quarters. As long as earnings keep growing, there's going to be a level of support for stock prices regardless of the state of inflation, interest rates, and geopolitical risks. We've seen that play out over the past few months.

But these conditions can be damaging the longer they last. And that's what the Fed is suggesting will happen. While Wall Street didn't give a lot of weight to the September hike, persistently high bond yields and high oil prices from the war in Iran make future rate hikes potentially more consequential.

In 1994, the Fed raised rates aggressively in order to help prevent inflation from accelerating. The S&P 500 was able to produce a small total return that year while rallying the following year strongly.

From 2004 to 2006, the Fed tightened by more than four percentage points over a two-year period. Yet the S&P 500 again generated positive returns over that period.

But in 2022, the opposite occurred. The Fed raised rates aggressively in order to combat a post-COVID inflation surge. That year, both stocks and bonds fell sharply as the Fed response came too late to prevent the downturn.

Raising rates doesn't result in any one specific market reaction. They're a headwind but not necessarily the catalyst for a correction in stocks.

What I'd do with my portfolio

History shows us that stocks have both gained and lost during periods of rising rates. Which one might happen in 2026 is likely going to depend on other financial conditions. If companies can keep growing profits and see a reasonable return on all their AI spending, there's a strong case to be made that the S&P 500 can keep pushing higher.

But because of uncertainty about when the AI capital expenditure cycle will finally peak, as well as an inflation rate trending toward 4% and historically low consumer confidence, it's very far from a sure thing.

That's why I think buy-and-hold is probably the best approach here. If you have a long-term time horizon of 10 or more years, it's best not to bet on which outcome happens. If you decide to sell and the market keeps rising, you can seriously damage your long-term returns.

It's also worth reviewing how much of your current portfolio you have invested in tech, growth, and AI stocks. Even if you own something that's supposed to be broadly diversified like the Vanguard S&P 500 ETF (NYSEMKT: VOO), you still have about 40% invested in tech and 40% invested in just the 10 largest companies. That leaves you vulnerable to a correction where these positions could underperform.

The returns for the S&P 500 over the next 12 months could depend heavily on what the Fed decides to do next. So far, the economy has been resilient. But the long-term effects of higher-for-longer rates could still be coming.

David Dierking has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.