The Chances of a Federal Reserve Rate Hike Are Surging. Here’s What It Means for the Stock Market.

Interest rates in some parts of the economy were already rising in anticipation of the news. When the Bureau of Labor Statistics confirmed on Friday that the United States’ consumer inflation rate was indeed a lofty 3.4% in August, those rates edged even higher. The Federal Reserve now has little choice but to attempt to curb this inflation, and soon.

That’s what the market is suggesting anyway. Based on recent pricing and trading activity of Fed Funds Rate futures, the CME’s FedWatch report indicates a 90.3% chance the baseline interest rate will be raised by a quarter point this Wednesday.

That’s got implications for the stock market too.

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How higher interest rates can impact stocks

It’s not a guarantee, to be clear. The Federal Reserve’s FOMC (Federal Open Market Committee) isn’t obligated to deliver the policy changes the crowd expects. It’s not even required to adhere to its own long-term consensus forecast, recognizing that the United States’ ever-changing economic underpinnings are always nuanced.

Broadly speaking, though, the interest rates futures trading crowd usually gets it right; the Fed Funds Rate’s current target of between 3.5% and 3.75% likely will be raised to a new target range of 3.75% to 4% on Wednesday.

And this is a potential problem for the already-strained stock market too, for a couple of reasons.

The first stumbling block is pretty obvious. That’s the fact that the whole point of raising interest rates is to cool an overheating economy that’s allowing inflation to linger at dangerously high levels. By curbing the underlying problem before it becomes uncontrollable, the economy should normalize sooner than it might without any action from the Federal Reserve. See, higher interest rates not only make it less profitable for companies to borrow to invest in their own growth, but make it more expensive for consumers and corporations to use debt to purchase goods and services.

The problem? With the S&P 500 (^GSPC -0.25%) valued at more than 23 times its trailing 12-month earnings, many — if not most — stocks are priced as if the FOMC wouldn’t be imposing this growth-impeding rate hike quite so soon.

The other implication is less obvious, but a drag on stocks all the same. That is, with longer-dated bonds now offering interest rate yields higher than the dividend yields on even some of the market’s highest-yielding dividend stocks, income investors have good reason to at least consider swapping out some of their dividend payers for lower-risk fixed-income instruments. This migration can put more selling pressure on the (already frothy) overall market than you might think possible.

Perhaps the stock market’s biggest headwind right now, however, is the overhang stemming from the 45.9% chance of another quarter-point rate hike in late October. Uncertainty and sheer worry can weigh on the market as well.

Stay focused on your bigger picture

The prospect makes for riveting headlines, of course. Just don’t worry about them too much. Although rising interest rates can correlate with weaker market performance, they don’t necessarily correlate with or cause bear markets. Attempting to navigate the unpredictable impact of rate hikes could do you more harm than good. Just keep doing your job, which is finding, buying, and holding quality stocks.