Every time the Federal Reserve signals it is raising the Federal Funds rate, a familiar headline shows up: “Higher interest rates threaten stocks.” It sounds intuitive. It is also often an oversimplification. History shows the relationship between interest rates and stocks is far less mechanical than the conventional wisdom suggests and understanding why matters more for your portfolio than memorizing the theory.
The Logic Behind the Fear
The textbook argument around higher interest rates and stock returns is straightforward. Stock prices are, in theory, the present value of a company’s future cash flows and earnings. When interest rates rise, the discount rate used to value those future cash flows and earnings rises too, which mathematically lowers what a dollar of tomorrow’s profit is worth today. Higher borrowing costs can also slow economic and earnings growth, and richer yields on bonds and cash give investors a more competitive alternative to stocks.
All of the above is real. None of it is the whole story.
What History Actually Shows
If higher interest rates were automatically bad for stocks, every hiking/tightening cycle would look the same. History shows that is not the case.
For example, between June 2004 and June 2006, the Fed raised its benchmark rate from 1.00% to 5.25% in a steady, well-telegraphed series of quarter-point moves. Over that same stretch, the S&P 500 climbed from 1,140.84 to 1,270.20, a gain of 11.3%. Interest rates rose for two full years, and stocks rose with them, because the hikes were responding to a genuinely expanding economy.
The 2015–2018 cycle tells a similar story. The Fed spent three years gradually lifting interest rates as the post-financial-crisis economy found its footing. The S&P 500 rose from 2,043.94 at the end of 2015 to 2,506.85 by the end of 2018 (up 22.6%) even as interest rate policy moved steadily tighter the entire time.
In 2022–2023, the Fed did something quite different. It raised the Federal Funds rate by roughly 5.00 percentage points in just over a year, from an effective rate of 0.33% in March 2022 to 5.33% by July 2023, the fastest tightening campaign in four decades. The market’s reaction split into two distinct chapters. Calendar year 2022, when the bulk of the rate hikes occurred, saw the S&P 500 fall 19.4%. By the time the rate cycle’s endpoint arrived in July 2023, the index had gained 1.3% versus where it stood at the outset and 2023 alone delivered a 24.2% rebound as investors concluded the economy could absorb higher borrowing costs after all.
Three interest rate cycles, three different outcomes for the stock market, all involving rising rates. Direction of interest rates was never the deciding factor.
What Actually Drives Stock Returns When Rates Rise?
If it is not the interest rate hikes themselves, what is it? Four things tend to matter far more:
- The pace of change. Markets can digest a gradual, well-communicated tightening cycle far more easily than they can digest speed. The 2004–2006 and 2015–2018 cycles gave companies and investors years to adjust. The 2022–2023 cycle compressed the same magnitude of change into a fraction of the time, and the shock showed up immediately in valuations before earnings and sentiment had a chance to catch up.
- The reason behind the move. Rates rising because the economy is strong and demand is robust is quite a different signal than rates rising to stamp out runaway inflation. The former tends to coincide with earnings growth that can offset a higher discount rate. The latter creates a tug-of-war between slowing growth and tighter policy, which is exactly what played out in 2022.
- Where valuations started. A market trading at a rich price-to-earnings multiple has less cushion to absorb tightening than one trading at a modest multiple.
- Portfolio construction. What you own matters more than which direction rates are heading. A portfolio concentrated in long-duration bonds and richly valued growth stocks will feel a hiking cycle very differently than one balanced across sectors, maturities, and valuation styles. The construction of your holdings, not the Fed’s calendar, does most of the work in determining how exposed you actually are to rising interest rates.
Where We Stand Today
As of this writing, the effective federal funds rate sits at 3.63%, with the Fed’s target rate at 3.75%, well below the 5.33% peak of the last cycle, reflecting a period of gradual easing rather than tightening. Headline inflation is running at 3.5% year-over-year, with core inflation at 2.6%, still above the Fed’s long-run target but meaningfully cooler than the peaks of a few years ago. The 10-year Treasury yield is at 4.70%, near the top of its 52-week range of 3.95% to 4.71%, which tells you the bond market is still pricing in a combination of economic growth and higher inflation.
Against that backdrop, the S&P 500 has traded recently inside a 52-week range of 6,212.69 to 7,620.90 and is up 16.6% over the trailing twelve months. In other words: the market has continued climbing through a period of still-elevated rates. That is not an anomaly. It is the same pattern the historical cycles above would have predicted.
The Real Takeaway for Your Portfolio
The question “are higher interest rates necessarily bad for stocks” is really the wrong question. The better questions are: How fast is interest rate policy changing? Why is interest rate policy changing? And what is already priced into the investment markets?
That reframing matters because it shifts the conversation away from trying to predict, or time, the Fed’s next interest rate move, and toward the things a well-constructed portfolio can actually control: diversification across sectors and durations, quality of earnings, and a starting valuation discipline that leaves room to absorb surprises either way.
Rate cycles will keep happening. Headlines will keep oversimplifying them. Our job is not to react to the headline. It is to make sure your portfolio and your financial plan are built to hold up regardless of which way interest rates move next.
Disclosure
This material is provided by Gryphon Financial Partners, LLC (“Gryphon”) for informational purposes only. It is not intended as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy, or investment product. Facts presented have been obtained from sources believed to be reliable, though Gryphon cannot guarantee their accuracy or completeness. Gryphon does not provide tax, accounting, or legal advice. Individuals should seek such guidance from qualified professionals based on their specific circumstances.