Rate cuts and market performance: How the Federal Reserve’s pivot could impact investors

We recently learned that the Federal Reserve (Fed) lowered the fed funds rate by 0.50% almost exactly a year after pausing its cycle of rate increases. This rate cut was a foregone conclusion after Fed Chair Jerome Powell previewed the action during the Fed’s annual symposium in Jackson Hole last month. Still, it represents a major turning point for monetary policy and a recognition of a softening labor market.

There’s a general perception that financial markets tend to perform well when the Fed starts cutting rates. While there are supportive historical examples, this has not always been the experience. We need to understand why the Fed is cutting its policy rate for a better sense of how markets could react.

Differences between policy adjustments and cutting cycles

There are two primary scenarios in which the Fed reduces the funds rate: policy adjustments, or tweaks, most recently undertaken in 2019; and full-fledged interest rate cycles where the Fed either fights inflation or looks to support labor and growth. The differences between these scenarios can be seen in the duration and magnitude of rate cuts, which can have widely different implications for financial markets.

Cutting cycles. We found the Fed’s rate-cutting cycles are not usually the most positive environments for risk assets, as the two most prominent examples occurred in 2000 and 2007. Even at the onset of the COVID meltdown, markets initially plummeted on the announcement of large rate cuts tied to a weakening economic outlook, before ultimately posting strong returns over the following year. Generally, full-fledged cutting cycles tend to coincide with a deteriorating economic backdrop that could challenge equity markets and other risk assets. However, we have seen the S&P 500 Index higher over 3, 6, and 12 month periods, on average, in each of the last eight cutting cycles dating back to 1980.

Policy adjustments. Historically, when the Fed adjusts its policy rate, it results from realizing that it may have overtightened, with the most recent example occurring in 2018. This type of fine tuning tends to be short-lived when compared to a cutting cycle. These actions tend to be viewed by market participants as a “Fed Put”—or accommodative intervention by the Fed to stabilize markets and hinder declines—and therefore equity markets and risk sentiment tend to recover.

Picturing performance when the Fed starts cutting rates

Historically, equity markets tend to perform well in the twelve months following the first rate cut of a Fed cutting cycle, with the S&P 500 posting an average gain of 5.3% since 1980, though this figure is heavily influenced by the Great Financial Crisis. When stripping out the 2007-2008 data, the S&P 500 rose an average of 10.7% in the 12 months following the first rate cut after the end of a hiking cycle. However, average 12 month performance has been modestly negative in cases when first cuts were followed by a recession within one year.

Exhibit 1: S&P 500 price performance after initial rate cut

S&P 500 Index performance over various timeframes from January 1980 through September 2024. Sources: S&P Global, Macrobond

On the other hand, fixed income returns tend to be fairly consistent across the two scenarios. The 12 month performance of the Bloomberg US Treasury Total Return Index appreciated an average of roughly 7% in the year following an initial rate cut by the Fed.

U.S. Treasuries tend to provide consistent returns across all scenarios so, on average, they have historically performed better than equities in the months following the first rate cut.

Exhibit 2: U.S. Treasury Total Return Index performance after initial rate cut

Total return for the U.S. Treasury TR Index over various timeframes from January 1980 through September 2024. Source: Bloomberg, Macrobond

In short, equities have historically outperformed when there is no recession within one year after an initial rate cut. Conversely, when there is a recession within one year, Treasury returns edge out equities in the months following the first rate cut.

Rate forecasts remain fluid as the economic outlook evolves

We continue to anticipate an economic soft landing, which appears to be coming into focus as the U.S. labor market softens and inflation approaches normal levels. Ideally, this outcome would allow the Fed to stick with limited policy adjustments, which would be a positive development for markets, in our view.

We believe a soft landing remains the most likely outcome as economic activity appears to be normalizing towards longer-term growth levels while inflation continues to moderate towards the Fed’s target. We are seeing signs of a softening labor market, but this appears to be a shift towards more sustainable levels of job growth following the post-pandemic recovery rather than a severe contraction. Additionally, S&P 500 forward profit margins remain near all-time highs, and demand-side indicators continue to show resilience, suggesting that aggregate demand is being sustained without the private sector needing to overextend itself.

However, if economic growth slows more than anticipated, then the risk of a full-fledged cutting cycle would increase, which could weigh on the performance of risk assets.

The fed funds rate is poised to decline in 2024 by an additional 0.50% according to the Fed’s latest projections and a further 0.75% based on market pricing, which would put the Fed somewhere between a policy adjustment and a full-fledged cutting cycle. The Fed projects another 1.0% in cuts for 2025, while markets are currently pricing steeper cuts of just under 1.25%, which would put us near what the Fed views as the neutral rate and on the edge of cutting cycle territory.

Of course, these rate forecasts are fluid and dependent on economic developments. Moreover, many of the factors that contribute to economic conditions have behaved abnormally dating back to the onset of the pandemic era, and they’re just finally returning to normal more than four years later.

We believe it’s possible for the Fed to succeed in normalizing rates via a rate adjustment cycle while avoiding a protracted economic slowdown or risk-off rotation in markets. That’s precisely what the Fed is trying to achieve by starting cuts to preempt labor market deterioration before inflation has completely returned to normal.

How could the economic outlook impact policy decisions?

After examining a range of economic factors, we believe 1995 stands out over the past three decades as the most similar setup for the rate adjustment cycle that we anticipate looking into next year. It’s also possible that no historical period provides a perfect comparison. The COVID recession is unique as the first U.S. downturn in which household net worth increased, and the subsequent tightening cycle saw corporate net interest expenses fall while profitability rose. This anomaly stems from the extraordinary fiscal measures taken by the U.S., which continue to bolster household and corporate balance sheets today. At the same time, S&P 500 earnings are accelerating, with expanding margins. Despite these unprecedented conditions, investors may recognize historical parallels.

The 1995 rate adjustment cycle occurred during a period of disinflation and resulted in a soft landing for the economy, which avoided a recession. This example could offer parallels that may serve as a guide for corporate earnings and equity market performance in the coming quarters.

Earnings for S&P 500 Index companies rose by 12% over the year following the first rate cut in 1995. The S&P 500 soared more than 40% in the 18 months that followed, though mid- and small-cap stocks did not enjoy as much appreciation. We believe this setup is noteworthy as the earnings gap between the Magnificent 7 and S&P 493 closes, historically extreme concentration persists in the market, and because small caps will likely benefit from falling rates. Looking ahead, S&P 500 earnings are estimated to grow by roughly 13% in 2025, which could support further market gains.

While the current monetary policy cycle has compelled the Fed to contend with significantly higher inflation by maintaining peak rates for a longer period, we believe the U.S. economy can avoid a recession and stick a soft landing as growth gradually returns to trend. This moderation, combined with easing financial conditions, could be expected to help sustain corporate earnings growth and support equity markets.

However, if economic growth slows more than anticipated—either due to consumption challenges resulting from a deteriorating labor market or lagged effects from tighter financial conditions—then the risks of a recession would increase, which could weigh on the performance of risk assets.

So far, the U.S. economy has been resilient enough to withstand an extended pause in Fed rate hikes, but a series of rate cuts looms as the labor market has shown continued signs of softness. We expect the Fed to follow the lead of other global central banks, such as the Bank of Canada, the European Central Bank, and the Bank of England, by shifting toward a more neutral monetary policy, which we define as well under 5.50%.

With inflation expectations well anchored, our focus remains on any signs of weakness in labor market indicators to gauge the Fed’s potential response. If labor market conditions deteriorate more rapidly, it could accelerate the Fed’s pivot toward lower rates.

We thank Sam Kessler, Asset Allocation Investment Associate, for his contributions to the preparation of this article.