How Interest Rate Decisions Affect Stock Markets
The simple rule that hikes push stocks down and cuts push them up failed on the exact dates a careful investor would have bet on it.
On 3 January 2022, two months before the Federal Reserve's first rate hike of the cycle, the S&P 500 peaked at 4,796.56 (FRED, S&P 500 daily close, 2022). By 16 June 2022, with the Fed still raising rates, it had fallen 23.55%. The rule most investors are taught is that rate hikes push shares down and cuts push them up, and that rule gets the direction and the timing both wrong on those dates. We think the rule survives because it is the kind of one-line story fund commentary and broker notes repeat. Acting on it has cost European investors real money.
The Federal Reserve hiked eleven times between March 2022 and July 2023, taking the policy rate from near zero to a range of 5.25% to 5.50%, a total of 525 basis points (CBS News, July 2023). One basis point is one hundredth of a percentage point. If the rule held, shares should have fallen as each hike landed. They did not. After bottoming in October 2022, the S&P 500 recovered most of its loss through 2023 while the Fed was still raising, then climbed again as rate cuts approached in 2024. The 2022-2024 cycle inverted the textbook: shares fell before the hikes and rose during them.
What actually moves the price is the discount rate, not the headline
The rule fails because the policy rate is not the number that moves shares. The discount rate applied to companies' future profits is. The central bank changes the policy rate. The risk-free yield curve adjusts, meaning the return you can earn on safer assets such as government bonds changes too. The discount rate adjusts with the safe yield. When safe assets pay more, profits a company will earn years from now are worth less in today's money, so the price an investor will pay for those shares today falls. Earnings react last, because the real economy feels a higher borrowing cost only two to four quarters later. That gap is why the S&P fell on rising rates in 2022 and recovered on still-rising rates in 2023.
ECB board member Philip Lane described the same mechanism in a speech on 11 October 2022: higher discount rates pushed valuations down, while a lower equity risk premium pulled them up (ECB, Lane speech, October 2022). The equity risk premium is the extra return investors demand for holding shares instead of safe bonds. When investors will accept less of it, prices can hold up even as rates rise. That is why the S&P could fall 23.55% by June 2022 and then climb back even as the Fed kept hiking.
What fell in 2022 was the price, not the profit
The 2022 hikes were front-loaded. The Federal Reserve raised by 25 basis points on 16 March, then 50, then 75 at four meetings in a row through November (Federal Reserve, Open Market Operations). The ten-year US government bond yield, the benchmark safe rate investors use to discount a company's future profits, climbed from 1.51% at the end of 2021 to 3.88% by the end of 2022 (Brown Advisory, 2023). That 2.37 percentage point shift in the safe yield is what the S&P was repricing through the first half of 2022, when the index fell 23.55%.
The S&P 500 began 2022 at a forward price-to-earnings ratio of 21.7 and ended at 16.6, a contraction of nearly 25%, while the profit those companies were expected to earn fell only about 4% from its June 2022 level (Brown Advisory, 2023). The price-to-earnings ratio is what you pay for one euro of a company's annual profit. The price did almost all of the moving, the business very little. The Bank for International Settlements documented the same pattern a year later: "higher discount rates weighed on US equity valuations, even as expected earnings per share actually rose" (BIS Quarterly Review, December 2023). Across both years the price was tracking where investors thought rates were going, not how the companies were doing. The 2022 split between sectors made the channel visible. The Nasdaq, with profits arriving a decade out, fell about 33% peak to trough. Energy shares, whose cash arrives next quarter, rose. In 2022 the same Federal Reserve hike cycle hit Nasdaq and energy in opposite directions, because what was changing was the discount rate, not the underlying businesses.
You get paid for the surprise, not the move
Former Federal Reserve chair Ben Bernanke and Kenneth Kuttner found that a rate cut investors did not see coming was linked to roughly a 1% rise in broad share indices that day, while a cut already expected barely moved them (NBER, 2005). Most of that reaction came from a shift in the risk premium, not the safe rate. On 18 September 2024 the Fed cut by 50 basis points to a 4.75% to 5.00% range (FOMC statement, 18 September 2024). A textbook reading says a cut that large should lift shares. Markets had expected the move for months, so the cut carried no surprise, and the S&P 500 finished the day close to flat.
What we think this means for your portfolio
Your portfolio carries the same trade. The Federal Reserve cycle hits a company's share price hardest when its biggest profits arrive years from now. Long-duration companies, tech firms whose earnings sit a decade or more ahead, fall furthest when rates rise and rise furthest when rates fall. Your MSCI World ETF, the core holding for most European retail investors, is heavily weighted toward exactly the long-duration US technology companies that drove the Nasdaq down 33% in 2022. Said plainly: your largest holding is a leveraged bet on the US discount rate, not a diversified bet on the global economy that the country label suggests.
So the question is not where rates go next. If your portfolio has not changed since the policy rate was 0.25%, how much of its value today comes from the businesses you own actually performing, and how much is just the discount rate, waiting to move the other way?
