Stock Market Investors Just Got Bad News From the Federal Reserve. History Says a Big Drop Could Follow.

The U.S. stock market has performed well in the past year, in large part because of enthusiasm surrounding the artificial intelligence trade. The S&P 500 (^GSPC +0.79%) and Nasdaq Composite (^IXIC +1.52%) are up 20% and 27%, respectively, since June 2025. But investors recently got some bad news from the Federal Reserve.

Fed officials now anticipate at least one interest rate increase in 2026. That would mark the beginning of the fifth rate-increase cycle since 1999, and the last four cycles generally coincided with bear markets.

The odds of interest-rate increases in 2026 have increased substantially

In December, the Federal Reserve lowered the target range on its benchmark interest rate to 3.5% to 3.75%, representing a quarter-point reduction. At the time, the market anticipated at least two more quarter-point rate cuts in 2026, according to CME Group's FedWatch tool. But investors' expectations have changed because of the recent acceleration in inflation.

"The most natural path for the Federal Open Market Committee (FOMC) is to delay further cuts until the effects of tariffs, higher oil prices and other effects of the war in the Middle East, and the effects of artificial intelligence demand have faded," Goldman Sachs strategists wrote in early June.

The FOMC's latest economic projections reinforce that idea. The dot plot published after the June meeting indicates that 50% of Fed officials now believe at least one quarter-point rate increase will be necessary in 2026. That's up from zero in March. Moreover, about one-third of Fed officials expect at least two quarter-point rate increases this year.

Rate-increase cycles have frequently coincided with stock market corrections

Warren Buffett believes interest rates, especially those on Treasury bonds, are the single most influential variable in determining stock market valuations over time. Low interest rates generally make stocks more attractive, while high interest rates tend to make stocks less attractive. Interest rates have a direct and indirect impact on equities.

• The direct impact involves the compression of valuation multiples. In theory, a stock is worth the sum of its future earnings discounted to present value. Higher interest rates reduce the present value of future earnings, which compresses valuations because investors aren't willing to pay as much for stocks when relatively safe bonds offer reasonably good returns.
• The indirect impact involves higher borrowing costs. Business investments and consumer spending tend to slow when interest rates rise because it's more expensive to finance projects and purchases. In turn, corporate profits tend to grow more slowly, which can put downward pressure on stocks because equities are often valued based on earnings.

If the Federal Reserve does raise interest rates this year, it would represent the first increase in a new tightening cycle (i.e., a period where rates are rising). The Fed has made that pivot four other times since 1999, and the major stock market indexes usually fell into correction territory at some point in the next three months.

Data sources: Federal Reserve, YCharts. The chart above shows the maximum drawdown in the S&P 500 and Nasdaq Composite during the three-month period following the Fed's first interest-rate increase in a tightening cycle.

As shown, following the Fed's first rate increase in a tightening cycle, the S&P 500 and Nasdaq Composite have declined by an average of 10% and 15%, respectively, at some point during the next three months. In one instance, the Nasdaq actually fell more than 20%, meaning the index entered a bear market.

Of course, past performance is not a guarantee of future results, nor are interest-rate increases written in stone. In fact, Morgan Stanley economists believe the Fed will hold interest rates steady through the remaining months of 2026 as inflation cools more quickly than anticipated.

Nevertheless, investors should be prepared for volatility. Higher interest rates become more likely the longer inflation remains elevated, and rate increases could easily drive the stock market into a correction, particularly when valuations are already stretched. The S&P 500 currently trades at 20.1 times forward earnings, a premium to the 10-year average of 19.