The Fed officially started cutting this past Wednesday, framing the reduction in rates as preventative rather than reactionary. That is consistent with the breadth of economic data, which indicates an ongoing normal economic expansion.
Rate-cutting cycles during periods of low recession risk and supporting financial conditions typically see risk-on factors leading market internals. Fundamental factors outperform broadly as well, including Value, Momentum, and Growth. Returns leading into and following the FOMC have largely followed this pattern, and we expect that to continue near term.
Long-term, market trends are less a function of rate cuts and more tied to recession risks. During con-Recessionary cutting cycles, markets continue rising as cuts continue. If recession risk increases – financial conditions tighten, unemployment moves higher, spreads widen – rate cuts are not enough to sustain market gains.
With more than 4 Fed cuts being priced by the end of next year, earnings/margins strong, and consumer spending firm, financial conditions are likely to remain easy. That backdrop could change IF labor markets weaken materially from here or if inflation backs up, reducing the ability of the Fed to keep cutting rates in 2026. Until one or both of those trends looks likely, the path for market and risk factors is likely higher.
There are some headwinds to keep in mind, though. During both non-recessionary and recessionary rate cuts, S&P correlation and implied volatility tend to rise. That is consistent with a more uncertain backdrop and will eventually work against the risk-on trend that has taken hold over the past few weeks. Higher vol and higher correlations will also act to limit PE expansion. However, those are likely considerations for 2026 or possibly late in 4Q25.
Non-Recessionary Cuts Suggest Continued Market Gains: Trying to prevent a disorderly weakening of the labor markets, the Fed started its rate-cutting cycle on Wednesday. Spreads are narrow, unemployment is low, corporate profits are strong, and consumer spending trends are firm. This is a protective cut in a non-recessionary backdrop. The breadth of data is today and has been for several quarters, consistent with a stable economic expansion.
During non-recessionary rate cuts, factor leadership tends to be more risk-on tilted. Earnings Turbulence and Liquidity usually lead at the expense of Low Volatility. The window is very narrow, but internals have largely followed that pattern so far. Most fundamental factors have outperformed, too, including Value, Momentum, and Growth, all of which are in line with our regime-based expectations.
Early Cyclicals have taken leadership for now, especially Technology. Staples has been the worst performing sector. Early Cyclicals are likely to outperform Defensives given the path of rate cuts expected through year-end and continued economic strength.
Longer-term, market performance and internals following the start of rate cuts are tied to subsequent recession risk. For the Fed rate-cutting cycles since 1990, non-recessionary cuts saw the S&P continue to rise for several months following the first cut. During those periods, financial conditions also eased. During recessionary cuts, financial conditions were typically tightening INTO the cuts and continued to do so after.
Historically, there is a loose correlation between the real Fed Funds rate and financial condition changes. A lower real Funds rate usually coincides with easing financial conditions. Today’s backdrop is complicated somewhat because financial conditions are already exceptionally low and the real funds rate unusually high. We expect financial conditions will remain easy until the labor market starts to improve or inflation picks up materially. Neither is an imminent concern.
There is one headwind to consider. During both non-recessionary and recessionary cutting cycles, S&P short and long-term correlations and implied volatility tend to increase. More certain EPS estimates and the VIX returning to the low teens have helped drive the S&P higher and risk factors into leadership. If rate cuts reduce labor market risks, that backdrop should continue. That being noted, history suggests that when the Fed starts cutting rates, total uncertainty tends to rise, not fall.
