So what if the Fed hikes? What an interest rate rise could mean for stocks and bonds

Forward indicators are also pointing one way. Aside from the hot jobs report, the ISM Services Prices Paid index rose to levels not seen since the 2021 to 2022 inflation peak. This is a strong leading indicator for inflation.

Rate hike vs higher yields

Investors should bear in mind what a Fed hike could do to bond yields. It's easy to think that Fed hike = higher yields. Often, you'll hear that higher yields present a riskier backdrop for stocks and this favours steady cash flow from defensives and staples – strong free cash is good, but steady earnings is not what it takes when you can get 5% risk free and when the Fed is saying that economic growth and demand warrant a hike. And investors should realise that, counterintuitively, a Fed hike can equal lower rates overall.

Whilst a hike raises short-term rates, it could re-anchor long-term yields and actually drive down the long end of the curve, reducing term premia (when investors demand a higher return for holding debt for longer) and flattening the curve. A flatter yield curve could hurt financials like financials by raising short-term funding costs while their margins and interest income compress. Rate sensitive sectors like banks and bond proxies like staples, utilities and real estate could be tricky.

So, this goes back to why the Fed might hike: supply shocks are the new normal, but the economy is holding up just fine. That's partly because Washington is running a pro-cyclical fiscal policy and 6% deficit when the economy is at full employment. It's also because of the huge AI-driven business cycle and investment in this space. And productivity is improving. Atlanta Fed's GDPNow model currently estimates that real GDP is increasing by 4.7% (saar) in Q3, while labour input is steady. S&P 500 earnings growth in Q2 2026 was 50% and forward earnings guidance keeps going up.

Bull vs Bear flattening

True, the Fed does not have much control over rising fiscal deficits, but it can use interest rates to re-anchor expectations at the long end, which has moved out I think largely because the Fed got behind the curve on inflation and has been seen to welcome it. A credible move to get ahead of the curve would reduce anxiety about inflation, and crucially about fiscal dominance – ie that the Fed will artificially keep rates low in order to finance ever-increasing fiscal deficits. This can do a considerable amount of work to lower term premia and could present a more constructive outlook for risk assets than doing nothing. Failure to act now could send long-end rates up further, in other words risking a more drastic tightening cycle later on. For everything from AI to housing a couple of 25bps hikes matters very little – the long end is what counts.

I see three possible scenarios from next week's meeting

Hike, bull flattening: This is the best outcome for stocks. The Fed is seen as getting ahead of inflation, and the market starts to believe that one or two hikes now reduce the need for a much more damaging cycle later, lowering the implied terminal rate and bringing yields down at the longer end. 

Hike, bear flattening: Inflation credibility improves, but fiscal supply and real-yield pressures remain. This could play out longer term as a positive for equities but in the short term it will focus attention on the next meeting (in the absence of any forward guidance from Warsh). 

Hold, bear steepening: The Fed holds, keeping the front-end relatively well anchored while the long-end moves out further. This for me is the worst-case scenario for stocks and risk assets broadly. It hurts stocks because the discount rate moves up further and markets anticipate the need for more drastic tightening later on. The Fed ships some more credibility and people talk about fiscal dominance. A hold just invites the market to do the tightening through higher long-end rates which is more damaging to the economy and equity valuations.

Sectors to watch 

Energy, tech and materials are three sectors that have outperformed during rate hiking cycles since the 1990s, according to Barclays. Or as UBS put it succinctly in a note this week: "We continue to position for the upside in equities and continue to favour AI, power, and resources."

Energy: The State Street Energy Select Sector SPDR ETF, a proxy for energy stocks, is up 42% this year and remains well poised should the Fed hike. It's been led by gains for major holdings like ExxonMobil, Chevron and ConocoPhillips as oil prices have surged. Further down it's worth checking in on the oil refiners. UBS just delivered huge price target hikes to refiners Marathon Petroleum ($405 from $321), Phillips 66 ($300 from $235) and Valero ($450 from $355) on elevated refining margins with diesel crack spreads – a key profitability gauge – at all-time highs.

Materials: strength in gold and copper supports materials (XLB) and momentum remains strong across the commodity complex, including metals, agriculture and energy.

Tech. Higher rates increase the discount rate for future earnings, hurting a sector like tech, right? Certainly, higher long-term bond yields punish longer duration growth stocks like tech. But a rate hike or hikes that flatten the yield curve would likely act as a tailwind for the sector given strong earnings growth momentum. I think the macro situation has clouded things a bit for tech and multiples have come in quite a bit. 

Healthcare: It may be due a pullback as it's usually seen as a defensive hideout. But investors might want to view it as more of a growth story. Moderna and Merck's recent cancer vaccine trial and news from AstraZeneca on its COPD drug are a couple of indicators that in the words of Ed Yardeni, the "the drug development cycle is turning".

Overall, US stocks tend to fall in the month after the first hike in a cycle, but usually rally in the 6-12 months after.

Ultimately the bond market reaction will help show the way – and it will also show whether higher yields have been mainly about doubts around the Fed's resolve to combat inflation or if fiscal fragility – rising deficits – is the main worry. Before all this we have Friday's CPI inflation print, which could make all of this moot.