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Rate Hikes, Returns and Recessions

We look at whether rate hikes should really be feared, based on what has happened to stocks in past rate hike cycles.

The market is preparing for the Fed to finally lift off from its “zero interest rate policy,” putting pressure on stocks so far this year. Today we look at whether rate hikes should really be feared, based on what has happened to stocks in past rate hike cycles.

The data isn’t as scary as you might expect. In short, it’s worth remembering that rates are generally rising because the economy is strong. And when the economy is strong, stock earnings are also usually growing.

It turns out that recessions are what we need to worry about much more. And in recessions, the Fed is actually (usually) cutting rates.

Rate hikes affect valuations and PE multiples

We’ve previously discussed the headwinds that rate hikes cause for stocks. Historically, as rates rise, the price-earnings ratio (PE) of the market falls. That’s consistent with how valuations work – a larger discount factor makes future earnings worth less to an investor today.

However, there are two halves to the PE ratio: prices and earnings. If earnings rise, stock prices can stay flat or also rise even with climbing interest rates. In fact, that’s exactly what happened in 2021.

Looking at selloffs over time

Given the market selloff so far this year, with the S&P hitting a technical “correction” this week, down 10% from its recent highs, we look first at market drawdowns and the interest rate cycles. 

The data in Chart 1 shows Fed rates going back almost 70 years (orange above the axis). It shows a number of rate cycles. We shade rate hike cycles yellow, including the Volcker-led rate cycle to crush runaway inflation in the early 1980s.

We also show rolling one-year drawdowns in stocks (purple below the axis) and color periods of recessions in blue.

If we add circles to show the maximum drawdowns in rate hike cycles (orange) and recessions (blue), we start to see that most of the largest selloffs are blue (recessions). In contrast, the selloffs in rate hike cycles, especially since 1975, are mostly much smaller corrections.

Interestingly, looking at this from a valuations perspective, selloffs still happen even with super low interest rates, like we saw in the 1950s and again since 2004.

So, it seems we should worry much more about a recession than rate hikes.

Chart 1: Stock market drawdowns against rate hike cycles and recessions

Stock market drawdowns against rate hike cycles and recessions

Recessions have much bigger drawdowns

In fact, the data supports this. The average correction in the S&P 500 during rate hikes (orange circles above and bars in Chart 2) is around 15%. In contrast, when there is a recession (even if it overlaps with a rate hike cycle), the average drawdown in stocks is almost double (blue circles and bars).

That seems to confirm that stock market corrections are much more dependent on the business cycle than the rates cycle. That makes sense—during rate hike cycles, companies have strong demand and revenue growth recessions. Whereas, during recessions, unemployment and spending usually contract.

Chart 2: Average stock price correction severity during recessions and different rate regimes (%)

Average stock price correction severity during recessions and different rate regimes (%)

Sadly, a rate hike cycle often leads to the next recession (many, but not all, yellow zones in Chart 1 are followed by blue zones). Some, as Chart 2 shows, even overlap.

This is why some economists are already worrying whether the Fed can engineer a “soft landing” for the economy, which is where rate hikes slow the economy and inflation but don’t cause a recession.

Complicating the Fed’s job is outside influences that may also slow the economy, including huge fiscal stimulus from 2021 that will fade from spending in 2022, combined with the impact of Covid that could either shock (in the case of more Covid) or relieve (if Covid retreats) employment and supply-chain constraints.

The other interesting fact about rates and recessions is that the Fed is usually quick to act to support the economy and reduce the severity of the recession and that historically always means rate cuts.

Stock returns during rate hike cycles are almost always positive

Although drawdowns are bad, investors should care more about returns.

If we look at average returns historically, we see that when the Fed has hiked rates, market returns are usually positive (Chart 3).

Going back to the mid-1950s, annualized returns for the S&P 500 during rate hike cycles are mostly positive, with nine out of the 12 periods gaining.

The average return across all periods is about 4% per annum (Chart 3, grey line), and even higher if dividends are included. Interestingly, returns have been positive and above average for each of the last three cycles.

In short, rising rates usually equals a strong economy, which is usually good for companies, leading to earnings growth. That earnings growth more than offsets the valuation impact of higher rates.

Chart 3: Annualized S&P 500 return during rate hike cycles (%)

Annualized S&P 500 return during rate hike cycles (%)

In Chart 3, we classify rate hike cycles as spanning from the date of the first hike in the cycle to the last hike, using the target Fed funds rate since the early 1970s and the effective Fed funds rate before that.

A couple of cycles are worth highlighting:

  • 1972-74: which saw a negative return, overlapped with the 1973-75 recession.
  • 2015-18: saw drawdowns start before the rate hikes started, as we have seen this week, yet the S&P saw annualized returns of 6% during the whole period of economic expansion.

The 2015-18 cycle also began after the Fed ended an earlier quantitative easing (QE) program, similar to now. Although it’s not the same: inflation, spending and unemployment are much stronger now than they were in 2015.

It's also important to keep things in perspective. Even if the Fed hikes four or five times next year, as the market expects, it still leaves the Fed Funds rate at historically low levels near 1.0% at the end of the year. That’s well below the levels that led to the largest drawdowns in Chart 1 and likely well below inflation, even if inflation comes down from current levels.

Selloffs are normal; the economy is more important for markets

In short, this data shows us two things. Selloffs and volatility are normal in almost all types of interest rate regimes. And although rate hikes impact valuations, they happen because the economy is strong, which means companies and stocks usually do OK, despite the hikes. For investors, recessions are a much bigger worry.

Michael Normyle, U.S. Economist at Nasdaq, contributed to this article.

Phil Mackintosh


Phil Mackintosh is Chief Economist and a Senior Vice President at Nasdaq. His team is responsible for a variety of projects and initiatives in the U.S. and Europe to improve market structure, encourage capital formation and enhance trading efficiency. 

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