Fed Rate Hike Sparks US Stock Sell-Off
The Federal Reserve raised its target interest rate for the first time in over three years on September 16, sparking a decline in US stocks. The Fed's decision to raise the federal funds rate by 25 basis points to 3.75%-4.00% was met with a sell-off in U.S. equities, with the Dow Jones Industrial Average closing down 1.21%, the S&P 500 falling 0.45%, and the Nasdaq Composite dipping 0.01%. The 2-year U.S. Treasury yield rose 7.5 basis points to 4.738%, while the 10-year U.S. Treasury yield rose to around 5%.
The impact of Fed rate hikes on stocks is not direct, but rather affects equities through valuations, corporate borrowing costs, economic demand, and yield competition among asset classes. The most significant effect stems from stock valuations, which reflect investor expectations of a company's future cash flows. When the Fed raises interest rates, U.S. Treasury yields typically rise alongside them, elevating the market's risk-free rate and boosting the discount rates used in equity valuations.
High-valuation growth and tech stocks are particularly sensitive to interest rates because investors buying their stock are largely paying for future years of earnings growth. When long-term interest rates rise, the discounted value of long-dated profits declines, which can put pressure on their valuations. The 10-year U.S. Treasury yield's recent increase to around 5% has put simultaneous pressure on the S&P 500 and the Dow Jones Industrial Average.
Rate hikes will also increase corporate borrowing costs, as funding costs across the entire financial system usually rise when the Federal Reserve raises interest rates. This can squeeze corporate net profits and free cash flows, particularly for real estate, automotive, highly leveraged enterprises, and growth companies that require continuous financing.
The impact of Fed rate hikes on stocks is not limited to 'lower valuations'; it may also further alter companies' future earnings growth rates. Different sectors are affected by rate hikes to varying degrees, with tech growth stocks, real estate, consumer discretionary, small-cap stocks, and banks being particularly sensitive to rising interest rates.