US stocks have had a strong year so far despite economic uncertainty. The S&P 500 is up about 11%, the Nasdaq Composite has gained about 14%, while the Dow Jones Industrial Average is up about 7%. But the Federal Reserve’s latest rate decision has created a new risk for investors. The Fed raised interest rates last week for the first time in more than three years.
The rate hike matters because higher interest rates can put pressure on stocks. When the Fed raises its benchmark rate, borrowing becomes more expensive across the economy, including for consumers and businesses. The federal funds rate affects several other interest rates. These include rates on products such as credit cards and auto loans, according to The Motley Fool.
Higher rates can hurt US stocks
Higher borrowing costs can slow spending. Consumers may borrow and spend less, while businesses may reduce investments because loans become more expensive. That can eventually hurt company earnings. The Motley Fool said slower business and consumer spending can weaken corporate earnings growth.
Lower expected earnings can put pressure on stock prices. Stocks are generally valued based on expected future earnings, so falling earnings forecasts can make shares less attractive. Higher interest rates can also make bonds more attractive compared with stocks. Investors may move some money into bonds when they can get higher returns from relatively safer fixed-income investments.
10-year Treasury yield crosses 5%
The bond market is already showing the impact of higher rates. The yield on the 10-year US Treasury rose above 5% when markets closed on September 16, according to The Motley Fool. That was the highest 10-year Treasury yield since July 2007. This is important for stock investors because Treasury yields are closely watched when investors decide where to put their money.
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US stocks face rate hike risk
History shows that stocks have faced pressure when rates start moving higher. The Motley Fool examined the five Fed rate-hike cycles that began over the past 30 years.
The first rate hike in these cycles was followed by significant market declines within three months. The historical data looked at the maximum drawdown in the S&P 500, Nasdaq Composite and Dow Jones Industrial Average after the first hike.
S&P 500, Nasdaq and Dow losses
In March 1997, the S&P 500 fell as much as 7% within the following three months. The Nasdaq dropped 4%, while the Dow fell 7%, according to data from the Federal Reserve and YCharts cited by The Motley Fool.
In June 1999, the S&P 500 fell 8%, while the Nasdaq and Dow each declined 7%. These figures measure the biggest drop during the three-month period after the first rate hike of that cycle. The June 2004 rate hike was followed by another period of market weakness. The S&P 500 fell 7%, the Nasdaq dropped 14% and the Dow declined 6% within three months.
Fed may keep rates higher for longer
The December 2015 rate hike also came before a sharp market pullback. The S&P 500 fell 10%, while the Nasdaq dropped 15% and the Dow fell 10% during the three-month period, according to the data. The March 2022 rate hike cycle saw an even larger decline. The S&P 500 fell as much as 17%, the Nasdaq dropped 22% and the Dow declined 13% within three months.
Across the five rate-hike cycles, the average maximum three-month decline was 10% for the S&P 500. The average decline was 12% for the Nasdaq Composite and 9% for the Dow Jones Industrial Average, according to Federal Reserve and YCharts data. This does not mean the same thing will happen this time. Historical market performance cannot guarantee what stocks will do during the current rate cycle.
Fed rate hike outlook for 2026
The bigger concern for investors is that the Fed may keep rates high for longer. The latest projections suggest that another rate increase could come before the end of 2026. Most Fed officials expect another quarter-point hike in 2026. 16 of the 18 meeting participants expect another 0.25 percentage-point increase during the remaining months of the year.
If that happens, the federal funds rate would move to 4%–4.25%. That would put further pressure on borrowing costs and financial conditions. Fed officials also expect rates to remain at that level through 2027. This is the key “higher for longer” concern for investors because high rates could continue to affect borrowing, spending, business investment and stock valuations.
US inflation remains above Fed target
Inflation remains an important reason behind the Fed’s focus on rates. The Motley Fool said inflation has remained above the Fed’s 2% target for more than five years. The Fed’s latest move is aimed at bringing inflation back toward its target. Fed Chair Kevin Warsh has repeatedly said that restoring price stability is a priority.
The Fed’s rate decision was unanimous. All 12 members of the Federal Open Market Committee voted in favour of raising the federal funds rate by 0.25 percentage point.
AI earnings could support stocks
But stocks still have one major support: strong expected earnings growth. S&P 500 companies are expected to report about 31% earnings growth this year.
That would be an unusually strong pace of earnings growth. The Motley Fool said such growth, excluding periods immediately following recessions, has not been seen in more than three decades.
Artificial intelligence is one of the biggest drivers behind those earnings expectations. Companies are spending heavily on AI infrastructure, which is supporting growth across parts of the technology sector.
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That means the market has two competing forces to watch. Higher interest rates could pressure stock valuations and earnings, while strong corporate earnings and continued AI investment could support stocks.
What investors should watch next
Investor interest in AI could therefore remain important for the Nasdaq in particular. If enthusiasm around AI-related companies and infrastructure remains strong, the stock market could continue to find support despite higher interest rates, according to The Motley Fool.
The S&P 500, Nasdaq and Dow could still face a correction if the pressure from higher rates increases. The historical data shows that all three major indexes have experienced sizeable declines after the beginning of previous Fed tightening cycles.
Investors should therefore watch the next Fed moves closely. The key issues are whether another rate hike comes in 2026, how long rates remain at higher levels, and whether inflation continues to stay above the Fed’s target.
US Treasury yields and stock market
Treasury yields will also be an important signal for stock investors. A 10-year Treasury yield above 5% could make bonds more attractive than stocks. This could affect where investors put their money. Company earnings will also be important. If companies continue to report strong profits, this could support the stock market even when borrowing costs stay high.
AI spending is another key factor. Continued spending on AI could help companies grow their earnings. But if interest in AI slows down, the stock market could lose an important source of support. Past data shows that markets could see more ups and downs. But history cannot tell us exactly what will happen next. The last five Fed rate-hike cycles had different results, showing that every rate-hike cycle can affect markets in a different way.
The Motley Fool argues that investors should view a major market decline differently from a permanent loss. It notes that the US stock market has historically recovered from its previous drawdowns.
The key takeaway for investors is that higher rates could create more pressure on the S&P 500, Nasdaq and Dow, especially if the Fed keeps rates high through 2027. At the same time, strong earnings and the AI investment boom could provide support.
So, the next big question for Wall Street is not only whether stocks fall, but how the market responds to higher rates. Investors will be watching Fed policy, Treasury yields, inflation, corporate earnings and AI spending to see whether the current stock-market rally can withstand the higher-for-longer interest-rate environment.