History sends mixed signals on US post-pause interest rate cuts

A deep-dive into historical market reactions to US Federal Reserve interest rate cuts after a significant pause has delivered a mixed bag of impacts across equity markets, bonds, valuations and corporate earnings, according to a new paper from the Franklin Templeton Institute.

The commentary comes ahead of further expected monetary policy easing in the US before the end of the year, which presents a unique environment in which financial markets and broader macroeconomic trends will have to face a resumption in rate cuts after an extended pause.

Authors Chris Galipeau, Senior Market Strategist and Lukasz Kalwak, Market Strategist at the Franklin Templeton Institute, said interest-rate cuts after a pause have historically generally benefited both stock and bond investors.

“Equities appear likely to grind higher amid rising volatility. Not all cuts are the same. Early cuts in a cycle historically have been bullish and come with relatively low volatility,” they said in the paper.

“Interest-rate cuts after a pause, by contrast, have been typically associated with higher short-term volatility, but they have nonetheless averaged strong one-year returns across equity styles. On average, the Russell 2000 Index small caps gained about 20% and the Nasdaq Composite technology stocks gained about 25% one year after such cuts

“Fixed income also benefits. Fixed income has historically participated in these rallies as well, with US Treasuries returning around 6% and corporate bonds around 8% in the year following a pause-cut

“GDP growth has typically continued, and although corporate earnings have made only minor progress, price multiples have expanded significantly. Post-pause cuts have often coincided with P/E multiples expanding by over 20% within the first year, underscoring the powerful role of monetary easing in driving equity prices higher despite economic challenges.”

However, Galipeau and Kalwak noted that historical interest rate cuts in the aftermath of a pause did not typically support corporate earnings growth.

“In the current environment, one could argue that the Fed is already late in making its next cut, with a softer labor market and the drag from tariffs already likely to weigh on corporate earnings. That said, it is worth remembering that US corporate earnings have risen for seven consecutive quarters at a pace of at least 8.5%, suggesting that the resilience of US firms may be underappreciated in this framework.

“Still, the historical record speaks for itself: Much like equities, earnings outcomes have been highly variable, ranging from robust +37% earnings-per-share (EPS) growth in 2003 to a sharp -24% contraction in 2008.

“History shows that lower interest rates have supported economic growth. The reasons are straightforward: Lower policy rates reduce the cost of borrowing, making it easier for households and businesses to access credit. This translates into stronger consumer spending, higher levels of investment and, ultimately, stronger aggregate demand growth.

“One important point to remember is that the boost to growth from lower rates is rarely immediate. Historically, there has typically been a lag of around one year before the impact of easier policy is fully reflected in the real economy.

“This pattern is evident in the data: GDP growth often slowed in the months immediately following a post-pause cut, reflecting underlying economic headwinds. However, as the cycle progressed, the effects of cheaper credit and improved liquidity took hold. On average, GDP growth expanded by roughly 2%, underscoring the delayed but meaningful support that rate cuts have historically provided to the economy.”