Wall Street Expects Bad News From the Federal Reserve This Week. History Says a Stock Market Correction May Follow.

The U.S. stock market is having another fantastic year, driven by massive spending on artificial intelligence infrastructure. Year to date, the broad-based S&P 500 (SNPINDEX:^GSPC) has added 12%, the technology-heavy Nasdaq Composite (NASDAQINDEX:^IXIC) has advanced 13%, and the blue chip Dow Jones Industrial Average (DJINDICES:^DJI) has added 9%.

However, Wall Street expects the Federal Reserve to raise interest rates this week, potentially marking the start of a new tightening cycle. Historically, the first rate hike in a new tightening cycle has often correlated with stock market corrections. Here are the important details.

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CME Group 's FedWatch tool analyzes the prices of futures contracts tied to the federal funds rate to determine the market-implied probability of future interest rate changes. In other words, it shows what the futures market is pricing in concerning the Federal Open Market Committee's (FOMC) future interest rate decisions.

The FedWatch tool currently points to a quarter-point rate hike as the most likely outcome from the FOMC meeting ending on Sept. 16. Specifically, there is an 87% chance the target range for the federal funds rate will increase to 3.75% to 4%, up from 3.5% to 3.75% today. The market also expects another quarter-point rate hike at the December meeting.

The market expects higher interest rates because inflation has stayed above the Federal Reserve's 2% target since February 2021, meaning the central bank has failed to achieve price stability for 66 straight months. The responsibility for "sustained, elevated inflation sits squarely with the central bank," said Fed Chair Kevin Warsh in August.

New tightening cycles are relatively rare. In fact, the Federal Reserve has only initiated three rate-hike cycles in the last 25 years. After the first hike in each cycle, the S&P 500, Nasdaq Composite, and Dow Jones have, on average, suffered double-digit losses at some point in the next three months, as shown in the chart below.

Data source: Federal Reserve, YCharts. The chart shows the maximum drop in the S&P 500, Nasdaq Composite, and Dow Jones Industrial Average during the three-month period after the first interest rate hike in a tightening cycle.