The Fed Is Hiking Again: The Pace of Tightening Is Key

Executive Summary

With the Federal Reserve (Fed) raising rates for the first time in three years in September, we examined the six previous tightening cycles since 1994 and what they meant for equity and bond performance.

• Equity direction positive, volatility high. Twelve-month returns were positive in five of six episodes, but every episode saw a drawdown of at least 7%.
• Speed of hikes mattered. The cycles with the most aggressive tightening in the first 12 months, 1994 and 2022, had the lowest equity returns and the only losses for core bonds.
• Bonds were usually positive. Core bonds returned a median of 3.6% over 12 months. The yield curve flattened within six months in each period.
• Today’s inflation mix is unusual. The headline Consumer Price Index (CPI) is running a full point above the core, a gap exceeded only in 2022.
• The path from here is contested. The Fed’s median projection implies one more hike in 2026 and no change in policy in 2027. Markets price roughly three or four more hikes.

The September Hike in Context

The Fed raised interest rates on September 16 for the first time since July 2023, lifting the target range by 25 basis points (bps) to 3.75%-4.00%. The Fed cut six times in between those hikes. Over that period the S&P 500 returned 72.4%, or 18.9% annualized. The strong returns came despite stubborn inflation and elevated geopolitical and trade uncertainty. The question for investors is whether renewed Fed tightening materially changes the investing backdrop.

In this analysis we look back on the first rate hike of each tightening episode since the Fed began announcing its policy decisions in 1994. While unknowable at the time, five of the six hikes proved to be the start of hiking cycles. The lone one-and-done hike occurred in 1997.

Exhibit 1: Fed Rate Hike Cycles

Sources: Bloomberg, S&P Dow Jones Indices. Analysis by Franklin Templeton Institute. Performance from February 4, 1994, to September 16, 2026. Indexes are unmanaged and one cannot invest directly in an index. Indexes do not include fees, expenses or sales charges. Past performance is not an indicator or guarantee of future results. Important data provider notices and terms are available at www.franklintempletondatasources.com. We use CPI for a single consistent measure across all seven episodes. The Federal Open Market Committee shifted its semiannual inflation projections to use Personal Consumption Expenditures in 2000. Medians exclude the current episode.

Across the six prior episodes, headline and core CPI (which excludes food and energy) ran at medians of 2.4%. Today, the headline sits a full percentage point above the core, a gap exceeded only in 2022. Higher energy prices are driving this gap. Brent crude oil rose 54.6% in the 12 months before the Fed decision on September 16. Oil prices spiked in March after the US-Iran conflict began before dropping to $71.57 in June, but have since rallied back to $105.83 as of September 16.

Two other readings stand out. Ten-year US Treasury yields have risen far more than the median, and the trailing six-month S&P 500 Index return is higher than in all but one prior episode, 1997.

The Fed’s September Summary of Economic Projections (SEP) figures for both headline and core PCE at year-end 2026 were revised higher to 3.7% and 3.4%, respectively, while the 2027 estimates were unchanged at 2.3% and 2.5%, respectively. The SEP implies one more 25 bps hike by year-end and none in 2027. Fed funds futures imply three or four hikes between now and December 2027, as of September 18 of this year. Markets and the Fed disagree on the policy path.

Equities

Short-term equity performance was weak, except in 1997, but 12-month outcomes were mostly positive. The three-month return was negative in four of the six periods, with a median return of -3.3%. The 12-month return was positive in five of the six periods, with a median return of 8.1%.

It is notable that the two periods with the fastest hiking pace also had the worst returns. In 1994 the Fed took the fed funds rate 300 bps higher in the first 12 months and in 2022 the Fed raised interest rates 450 bps. These were the episodes with the lowest three-month and 12-month returns.

Looking at other major indexes, the median three-month return has been negative for Russell 1000 Value, Russell 1000 Growth, Russell 2000 and MSCI EAFE. The median three-month return for the MSCI EM Index was positive but it had the lowest median 12-month return. Small-caps had the highest median return one year after the first hike.

The ride for equity investors has not been smooth. The median drawdown during the 12 months following the initial hike was 11.4%. Every episode saw a drawdown of at least 7%.

Fixed Income

In fixed income, history shows us that the yield curve has typically flattened both going into and after the first hike.

Why has the yield curve been flattening? Short-end yields—such as two-year yields—are the most closely correlated with the fed funds rate. They therefore have typically risen with Fed hikes or at least held within a tight range, with the exception of 1997 when yields fell 72 bps in the 12 months following the hike. Two-year yields moved the most in the two aggressive cycles. Twelve months after the hike, yields were 320 bps higher in 1994 and 304 bps higher in 2022.

At the longer end of the curve, the reaction to Fed hikes has been less consistent. Exhibit 7 shows 10-year yields. These rose meaningfully in 1994 and 2022, although less dramatically than two-year yields. By contrast, 10-years rallied in 1997 and 2004, were fairly range-bound in 1999, and rallied in the first six months of 2015 before selling off at the end of the 12-month period.

For total-return investors, the key question is how bonds have performed after initial Fed hikes. Exhibit 8 provides the answer. Contrary to conventional wisdom, bonds, as represented by the Bloomberg US Aggregate Index, have held up quite well. There are two clear risk scenarios: 1994 and 2022. Outside these two episodes in which the Fed hiked most aggressively, bond performance has been solid.