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We're going to focus on the US in this article for simplicity, but it could actually apply to Europe as well. In the last two decades, every time interest rates in the US have risen and stayed at a high level, the stock market has fallen. Let's try to explain the relationship. Please take a look at the following graph; the blue line represents the evolution of interest rates, and the gray areas, the periods in which the US has entered into recession:

Source: US Federal Reserve.

Every time interest rates have reached a level above 5% (in November 2001 they reached 6.51% and in July 2007 5.26%), there has been a recession in the US. Please note that the Fed "anticipates" the arrival of the recession by starting to lower rates a little before it arrives (there are economic indicators that allow us to predict, to a certain extent, that a recession is coming).

The following chart takes us to the heart of today's topic. The blue line indicates the interest rates of the FED. The red line, the evolution of the SP 500, the most important stock index in the US (and the world). Please note that the stock market rises while rates rise. And that there is a moment when the stock market begins to fall; in the 2000-2002 crisis, the FED kept rates high while the stock markets fell, and in the 2007-2009 crisis, the FED lowered rates before the stock markets began to fall.

As much as stock market operators insist on believing otherwise, the Fed and the various central banks of the world do not consider "pampering" the stock markets their main task. Its main task is to fight against inflation (ECB and FED) and ensure the health of the labor market (in the case of the FED). In the following graph, it can be seen how the FED raises interest rates (black line) when inflation (blue line) rises. The exceptions are when the Fed believes a recession is imminent, is in a recession, or has just emerged from a recession. Raising rates when the economy is in trouble is disastrous.

The relationship between all these variables is relatively simple. It all starts with inflation at a level higher than what is considered “acceptable”. Automatically, the FED raises rates. The rise in rates controls inflation, but causes problems for companies and individuals to finance themselves, and inevitably leads to a recession. The recession causes a drop in corporate profits, which causes the stock markets to fall. With inflation controlled (or in the process of being controlled) and a recession affecting the economy, the Fed lowers rates to boost the economy. And so the cycle begins again, since low rates are a breeding ground for inflation.

In recent years, in addition to low interest rates, we have seen central banks flood the market with money to fight COVID. And that factor has further fueled inflation.

Interest rates continue to rise. In the US, they will reach 5.75% (if the FED follows its roadmap). And, as usual, those high rates typically result in a recession and a stock market crash.

The H&B team.


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