Why rate cuts could be bullish

The Fed appears poised to cut rates next week—potentially restarting the rate-cutting cycle that began a year ago but has been on hold so far in 2025.

Many investors think of lower interest rates as bullish for stocks. But history shows that rate cuts alone don’t reliably predict market direction. Rather, why the Fed is cutting is crucial in determining how the market subsequently performs.

My research focuses on analyzing market history to uncover patterns and probabilities that can help inform investors’ outlook and challenge their assumptions. Based on the current economic and market setup, I believe a rate cut from the Fed next week is likely to be a positive indicator for the stock market overall.

More specifically, I believe a resumption of the rate-cutting cycle could finally breathe life back into the housing market—and could kick off a bull run for one market segment in particular.

Why resuming rate cuts could be bullish for stocks

Looked at in isolation, the Fed’s actions have less predictive power than investors might think. Just because the Fed is cutting rates, or cutting rates after a pause, does not mean that stocks will necessarily go up.

What really matters is why the Fed is cutting. When the Fed has cut rates because it must—in response to a recession—returns have been poor. When the Fed has cut rates because it may—meaning inflation is low and growth is slowing, but not negative—returns have historically been strong. In other words, if you want to bet on which way stocks go from here, you have to decide if you think we’re heading into recession or not.

Much has been made of recently reported weakness in the job market, with some investors extrapolating that this weakness is a sign of looming recession. But remember that jobs numbers are inherently a backward-looking indicator—they only tell us where the ball has been, and not necessarily where it’s going.

What I find more convincing are certain leading indicators, meaning metrics that turn before the economy does. For example, CEO business confidence saw a big jump recently, with CEO expectations for conditions in their own industries rising by 30% over the previous quarter, according to data from The Conference Board and Haver Analytics. CEOs don’t turn optimistic on a whim. They typically react to tangible improvements and increasing demand visibility (which in this case, they may be seeing as a result of the new tax law). In the past, jumps in confidence like this have been leading indicators of future earnings growth and economic growth.

This is not to say that recession is completely off the table as a possibility, but I believe recession risks are limited right now. And if the economy does keep growing, and the Fed does resume rate cuts next week, it could create very bullish conditions for US stocks. In fact, in past periods with similar conditions, stocks got a lift not only from rising expected earnings growth, but also from rising valuations like price-earnings ratios (PEs).

Falling rates could bring the housing market out of its deep freeze

While I don’t believe the broader US economy is in recession or likely to soon enter one, some specific segments of the economy have seen their own limited contractions.

One of those is housing, which has been in what I would call a rolling recession. Home sales contracted steeply in 2022, then bounced off those levels before slipping back into contractionary territory this spring. It’s not hard to understand why: Affordability is now close to its worst levels on record—the result of a sharp rise in home prices during the pandemic, followed by the surge in mortgage rates as the Fed was hiking in 2022 and 2023.

Historically, home sales tend to rise following Fed rate cuts—but only if long-term interest rates, including mortgage rates, decline in tandem. (Remember that the Fed only controls very short-term interest rates, while market forces drive long-term rates.) Again, it’s easy to understand why: Lower mortgage rates boost demand from homebuyers.

However, this was the key link that didn’t work a year ago. While the Fed cut its benchmark interest rate by a full percentage point from September to December of 2024, long-term interest rates like those on the 10-year Treasury and 30-year mortgages instead rose over the same period.

Usually, when that link doesn’t hold it’s because either inflation is high or economic growth is exceptionally strong. Last year, for example, the Consumer Price Index excluding food and energy (aka core CPI) was still close to an important 3.5% threshold level, around which rate cuts tend to have less of an impact on long-term interest rates.

The good news is that the inflation backdrop looks much better today than it did a year ago. And in my opinion, the odds are higher that rate cuts will translate into lower long-term yields, lower 30-year mortgage rates, and a revival of new and existing home sales.

These stocks could offer a sweet spot

Putting all these themes together, what I see is a potentially bullish outlook for stocks, against the backdrop of a strong economy and falling rates.

This could be a healthy environment for cyclical sectors, meaning sectors like technology, financials, and consumer discretionary, that tend to rise and fall in tandem with the economy. Historically, in non-recessionary environments, cyclical sectors have outperformed by 2 percentage points on average in the 12 months after the Fed started cutting rates. By contrast, defensive sectors like utilities, health care, and consumer staples have underperformed by 3 percentage points on average in such environments.

But there’s one market segment that stands out to me for its potentially strong setup: homebuilders.

Homebuilders are highly interest-rate sensitive and offer the closest correlation to home sales that you can find in the stock market. Not surprisingly given the slump in home sales, homebuilders have broadly underperformed over the last year-plus and were recently in their bottom quartile of relative valuation. This combination of falling rates and low relative valuations has historically delivered strong odds of outperformance—nearly 80% in similar periods since 1970.

The setup isn’t flawless, but those low valuations improve the risk-reward profile. For example, even if home prices decline from here (which typically is bearish for homebuilders), those valuation levels could help buffer the downside—with builders experiencing only 3 percentage points of underperformance in such periods historically. On the flip side, if home prices can simply hold their ground, history suggests the upside could be significant—with builders experiencing 30 percentage points of outperformance in similar periods historically.

Fed cuts don’t come with a manual. But combining historical patterns with today’s backdrop can help spotlight where the setup looks most promising.

Potential risks

What could go wrong with this setup? Many investors might point to the risk of recession. And as I said above, recession certainly isn’t off the table.

But personally I think the greater risk is actually the reverse—that economic growth could reaccelerate. If growth were to tick up to a level of 4% to 4.5%, it would likely push long-term interest rates higher.

That kind of scenario might put a wrench in my thesis on homebuilder outperformance. But economic growth of that level, even if it’s accompanied by higher rates, usually hasn’t been a problem for the stock market.