As widely anticipated by the market, the Federal Reserve is expected to initiate interest rate cuts at its September 2025 policy meeting, largely due to recent weak U.S. employment data and easing inflationary pressures. However, there remains considerable disagreement regarding the exact magnitude of the cut. For U.S. stock investors, the pressing question is: how will this affect the market?
Conventional wisdom holds that rate cuts typically benefit the stock market—by lowering borrowing costs for businesses and consumers, they stimulate economic growth and boost stock prices. Yet reality is more complex. The impact of rate cuts on equities varies significantly depending on the economic environment. Moreover, investors must be wary of the “buy the rumor, sell the news” effect, where good news can sometimes trigger a market decline once it materializes.
This ambiguity is clearly reflected in the performance of the past four major rate-cutting cycles:
Lara Castleton, U.S. Head of Portfolio Construction and Strategy at Janus Henderson Investors, points out: “To gauge future market direction, you first need to understand why the Fed is cutting rates.” Market reactions ultimately hinge on how investors interpret the central bank’s intent: Is it a reactive move to an impending recession, or a proactive measure to engineer a soft landing?
This also explains why traders are closely watching the size of the first cut. A 50-basis-point reduction could be seen either as a panicked response to an economic crisis or as a confident, decisive move at the beginning of an easing cycle. A preemptive or “insurance” cut (“Good” Cut) typically bodes well for stocks, as seen in the 1995 cycle. Conversely, a recession-response cut (“Bad” Cut), implemented to rescue a faltering economy, often leads to negative market reactions.
Research shows that earnings growth is a more reliable predictor of stock market returns than interest rates alone. When accelerating earnings growth coincides with falling rates, the S&P 500 has delivered an average return of 14% over the following 12 months—significantly higher than the 11% return when rates fall alone, and far above the 7% return when earnings decline alongside rates. It is worth noting that following the Q2 earnings season, constituents of the Morningstar US Market Index achieved over 10% annualized earnings growth.
The unusually wide gap between the federal funds rate and the inflation rate is also a positive signal—it indicates that the Fed has ample room to cut rates if needed.
According to the CME FedWatch Tool, market expectations for the rate cut have been highly volatile: the probability of a 50-basis-point cut rose from 30% a week ago, to 50% last Friday, and further to 61% on Monday. Even as the Fed begins cutting, market anxiety persists. With the economy slowing and rate cuts underway, investors are questioning whether the Fed has acted too late and opened the door to a recession. Moreover, the market’s 24% gain over the past 12 months has already partially priced in the rate cuts, potentially limiting further upside. That said, a true soft landing could still open new pathways for stock gains.
Investors are advised to position for two possible scenarios within their core portfolios. Defensive stocks and rate-sensitive REITs can serve as buffers in case of a hard landing. If a soft landing is achieved, small-cap stocks—which have underperformed in recent years—could see a breakout. Despite their higher volatility, small caps offer attractive valuations compared with the increasingly expensive mega-cap tech stocks. Additionally, rate-sensitive sectors such as financials and real estate are also likely to benefit from lower rates.
