Why Rate Cuts Aren’t Always Bullish

“Policy rate cuts = higher equities” is intuitive but only half true. Rate cuts activate two forces at once. One is valuation support via a lower discount rate, and the other is risk aversion driven by a slowing economy and downward earnings revisions. Historically, equity market reactions diverged sharply depending on whether cuts coincided with a recession or not. This post reviews past Fed easing cycles against NBER business cycles and subsequent S&P 500 returns to distill the conditions under which rate-cut regimes tend to favor or hurt equities. It ends with a practical checklist you can use in real-time.

The Two Axes of Cuts for Equities: Valuation vs. Earnings

Rate–valuation channel
  • A decline in policy rates and Treasury yields lowers the cost of capital. In DCF models, a lower discount rate raises the present value of the same cash flows, driving multiple expansion.
  • Growth stocks (especially those with a high share of cash flows far in the future) and long-duration assets benefit more.
Macro–earnings/credit channel
  • If cuts occur amid economic downdrafts, earnings downgrades, wider credit spreads, and rising default rates offset or overwhelm the valuation effect.
  • In recession-linked cuts, equity troughs more often coincided with the point when earnings and spreads stabilized—not with the “first cut.”

The crux is why the Fed is cutting. Are they “insurance cuts” aimed at sustaining growth as inflation cools (a soft landing), or “recession cuts” responding to an ongoing downturn? That fork mattered.

Historical Cycles: Insurance Cuts vs. Recession Cuts

The cases below summarize typical patterns after the first FOMC cut, aligned with NBER cycle dating. Return descriptions focus on direction and approximate magnitude.

Insurance (soft landing) cut examples
  • 1984–85 mid-cycle adjustment: Gradual cuts to balance inflation and real activity. In 1985 the S&P 500 posted double-digit gains. The earnings cycle didn’t break—that was decisive.
  • 1995 mid-cycle adjustment: After forceful 1994 tightening, the first cut came in July 1995. Twelve months later, the S&P 500 was up roughly ~20%. ISM Manufacturing hovered near 50 then re-expanded, and credit spreads stayed stable.
  • 1998 LTCM/EM shock: Three cuts from September to November calmed financial stress. Twelve months later the S&P 500 was up more than 20%. The real economy avoided recession, and the IT investment/productivity narrative persisted.
  • 2019 insurance cuts: First cut in July. Easing trade uncertainty and ample liquidity supported equities; 12 months on (even spanning the early pandemic shock), the S&P 500 was in the high single-digit to low double-digit gain range. HY spreads largely stayed within 300–400 bps.

Common threads: HY OAS didn’t sustainably break above 500 bps, ISM New Orders quickly recaptured 50, and EPS revisions turned higher. In other words, cuts got ahead of earnings damage.

Recession (hard landing) cut examples
  • 2001 dot-com bust: Emergency cut in January 2001; NBER dates recession from March. Twelve months later, the S&P 500 was about -15%. Earnings collapsed and the tech bubble unwind overwhelmed valuation support.
  • 2007–08 Global Financial Crisis: First cut in September 2007. Twelve months later, the index was down more than -20%. Deleveraging, a credit crunch, and a spike in HY spreads (above 700 bps) hit equities hard.
  • Early-1990s recession: Cuts began, but Gulf War uncertainty and credit deterioration drove a roughly -20% peak-to-trough S&P 500 drawdown, with a sustained rebound only after the economic trough.

Common threads: In the 6–9 months after the first cut, earnings estimates kept falling; HY OAS jumped to around 600 bps or higher; and unemployment approached or triggered the Sahm rule signal (+0.5 pp versus the cycle low). In short, “a cut” was a signal that the slowdown was deepening, and equities continued to price in worsening fundamentals for a while.

In summary, in insurance-cut regimes, the median 12-month return was solidly double-digit, while in recession-cut regimes, the 6–12 months after the first cut tended to be negative or extremely volatile.

Leading Indicators That Separate the Patterns: What to Watch

1) The yield curve and the nature of re-steepening
  • When the 2s–10s inversion unwinds via bull steepening (long yields dropping), it has often signaled growth concerns. Bear steepening (long yields rising) has more often accompanied growth-reacceleration hopes.
  • In recession-cut episodes, equity volatility tended to spike around the un-inversion.
2) Credit spreads and liquidity
  • HY OAS above 500–600 bps strongly indicated damage to the growth/earnings cycle. In insurance-cut regimes, it mostly stabilized below ~400 bps.
  • Track signs that short-term funding stress is easing, e.g., CP–OIS spreads and financials’ CDS.
3) Bottoming in real activity indicators
  • When ISM Manufacturing New Orders recovers to 50 and ISM Services holds in the mid-to-high 50s, equity downside risk tends to ease.
  • Labor momentum: If cuts follow a Sahm rule trigger (unemployment up ≥0.5 pp from its recent low), recession odds are higher.
4) Earnings and revisions
  • The point when analyst EPS revision breadth turns net positive tends to align with more durable equity inflections.
  • If revisions keep deteriorating right after cuts, multiples can compress instead.

Positioning by Scenario and Execution Checklist

A) When insurance cuts (soft landing) look more likely
  • Sectors/factors: Industrials, Semiconductors/IT hardware, Consumer Discretionary, Small caps, Quality growth. Among rate-sensitive REITs, favor names with strong balance sheets.
  • Asset allocation: Equities neutral to overweight; duration neutral to slightly long. Add to IG credit; be selective in HY.
  • Tactics: Leg in during the “hope–disappointment” swings around the first cut. Add exposure after confirmation from improving EPS revisions and steady spreads.
B) When recession cuts (hard landing) look more likely
  • Sectors/factors: Consumer Staples, Healthcare, Utilities, Low volatility (min vol), High quality (solid ROE/cash flows, low leverage).
  • Asset allocation: Equities neutral to underweight; increase long Treasuries/cash as hedges. Favor IG over HY in credit.
  • Tactics: Don’t treat the first cut as a “bottom” signal. Historically, it paid to add risk only after HY OAS peaked and EPS revisions stabilized.
Quick diagnostic checklist (practitioner-oriented, based on historical hit rates)
  • HY OAS < 450 bps, ISM New Orders ≥ 50, EPS revisions turn net positive, unemployment trend benign: scores toward insurance cuts
  • HY OAS ≥ 600 bps, ISM New Orders persistently < 47, EPS revisions worsening, Sahm rule near/triggered: scores toward recession cuts
  • If three or more line up, lean positioning toward that scenario

Common Pitfalls and Risks for Investors

  • “First cut = bottom” fallacy: In 2001 and 2007 cycles, the 6–12 months after the first cut were the most difficult. Lows came with “stabilizing earnings/credit,” not with the act of cutting.
  • Pace and path trap: A large cut in one go can itself be evidence of growth fear. Markets react more to the speed and forward guidance than the level.
  • Inflation re-acceleration: Cut too fast, and inflation can re-accelerate, risking re-tightening and renewed valuation pressure on equities.
  • Intra-sector dispersion: Even within growth, outcomes diverge with cash flow durability and balance sheet strength. “Lower rates = a party for all growth stocks” is not true.

Conclusion: Context, Not the Cut Itself, Drives Returns

Summarizing the data, when cuts occurred without a recession—insurance cuts—the S&P 500’s 12-month performance was generally double-digit positive (1984–85, 1995, 1998, 2019). In contrast, when cuts coincided with recession—recession cuts—post–first-cut 6–12 month returns were negative or wildly volatile (1990, 2001, 2007–08). What separated the outcomes wasn’t the rate level per se, but fundamental gauges like credit spreads, ISM, labor momentum, and EPS revisions. For current positioning, resist treating “a cut” as a mechanical buy signal; use the checklist to identify the regime, then scale and stagger entries accordingly.

Glossary

  • Discount rate: The rate used to discount future cash flows to present value; higher means lower present value.
  • Valuation/Multiple: How expensive the stock is relative to earnings/cash flow (e.g., P/E, EV/EBITDA).
  • Soft landing: Inflation cools without major damage to growth and employment.
  • Hard landing: Tight financial conditions lead to a sharp slowdown in growth and employment (recession).
  • NBER: U.S. private research group that officially dates business cycle peaks and troughs ex post.
  • FOMC: The Fed’s monetary policy committee.
  • Yield curve: Differences in yields across maturities. A negative 2s–10s spread is an “inversion.”
  • Bull/Bear steepening: Curve steepens with long yields falling (bull) or rising (bear).
  • HY OAS (High Yield Option-Adjusted Spread): Junk-bond spread; a sensitive gauge of economic/credit risk.
  • ISM PMI/New Orders: Institute for Supply Management Purchasing Managers’ Index/New Orders; 50+ = expansion, below 50 = contraction.
  • Sahm rule: Recession risk signal when unemployment rises ≥0.5 pp from its recent low.
  • EPS revisions: Analysts’ upward/downward changes to earnings per share estimates.
  • Insurance cut: Gradual cuts to preempt recession; the real economy remains relatively resilient.
  • Recession cut: Cuts in response to an ongoing downturn; typically accompanied by earnings and credit deterioration.