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Recently, the market has become fixated on the Federal Reserve’s decision to potentially raise interest rates in the coming months and over the course of 2022. As a result, volatility has spiked and stock indexes have pulled back to start the year. The question that now looms is “what does an interest rate hike actually mean for investment returns going forward?”

To address this question, we can look to history for clues. While past performance is not indicative of future returns, we can review prior instances of stock and bond returns following the Federal Reserve raising interest rates for the first time. The data below illustrates that average U.S. stock and bond performance during the 12 months following the first rate hike is actually positive. While this may seem counter-intuitive given recent stock market performance, it’s important to remember why the Federal Reserve may raise interest rates.

The Federal Reserve is tasked with a dual mandate of i) maximum employment and ii) low and stable inflation. To achieve these goals the Fed has certain levers it can pull, such as raising or lowering short-term interest rates (the target for the federal funds rate). Theoretically – and simply stated, raising interest rates should encourage saving rather than spending, and thus may help manage inflation and cool an otherwise overheating economy.

Given the underlying reason for an increase in interest rates is often associated with a robust and quickly growing economy, should we be surprised that average stock and bond performance following the first interest rate hike is positive?

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