Stocks and Bonds After the Market Freakout: A Historical Look at the Fed Pause

The Federal Reserve's decision to reduce interest rates has sparked significant market turbulence. Alongside the rate cut, the Fed raised its 2025 interest rate projections by half a percentage point and abandoned its expectation that inflation would return to the 2% target next year. This marked a notable shift in sentiment, as just a few months ago in September, the Fed expressed confidence in meeting that target.

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As Thursday trading approached, the key question became whether the market sell-off would persist.

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Citigroup analysts provided timely insights by examining historical patterns of Federal Reserve pauses during previous monetary easing cycles. According to the CME FedWatch tool, the likelihood of another rate cut in January has dwindled to just 9%, making this analysis especially relevant. Citigroup reviewed instances since the late 1980s when rate cuts were followed by a pause, identifying 12 such occasions.

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Of these, three were accompanied by significant bond market sell-offs, similar to Wednesday’s events. These occurred in 1998 and 2003, which marked the end of rate-cutting cycles, and in 1989, which turned out to be a temporary pause.

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The Citigroup strategists, led by Dirk Willer, suggested that the 1998 and 1989 scenarios might offer useful templates for the current environment. In 1998, the Fed eased rates amid a strong U.S. economy, while in 1989, the economy eventually slid into a recession—a possibility that remains a contrarian call among Citigroup’s economists.

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Historical data indicate that when the Fed temporarily pauses rate adjustments, equity markets tend to rally for about a month before pulling back, as deteriorating economic data prompts further easing. In contrast, when the pause signals the end of the easing cycle, stock market rallies tend to be more sustained. For instance, in 1989, bonds initially sold off, followed by a stock market rally that later suffered a 10% drawdown. Meanwhile, the final cuts in 1998 and 2003 ushered in robust equity rallies over the subsequent three months. “Overall, the data is broadly constructive for equities, at least in the short term,” the Citi team concluded.

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Small-cap stocks, represented by the iShares Russell 2000 ETF (IWM), tend to outperform defensive sectors like utilities in end-of-cycle pauses. The analysts noted that small caps offer considerable upside in such scenarios, though during temporary pauses, their performance often remains range-bound. Thus, small caps currently appear more favorable compared to utilities.

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In the bond market, temporary pauses typically lead to higher yields, with more pronounced increases at the end of easing cycles. This trend reinforces Citigroup’s underweight position on U.S. rates within its global asset allocation strategy.

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Regarding the U.S. dollar, it tends to strengthen following the end of an easing cycle but shows more volatility during pauses. Meanwhile, gold prices generally rise in skip scenarios, regardless of whether the easing cycle resumes or ends.

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The Citigroup team also highlighted the impact of seasonality on market performance. Wednesday’s sell-off brought the S&P 500 back to its median trajectory for the year. Earlier in the year, the index had outpaced historical seasonal patterns, but after the Federal Open Market Committee (FOMC) meeting, it returned to typical performance levels. This shift, they noted, could set the stage for a year-end rally, commonly referred to as the "Santa Claus rally." Investors may not need to put away their Santa hats just yet.

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In terms of market performance, Wednesday saw a dramatic 1,123-point plunge in the Dow Jones Industrial Average. Early Thursday, U.S. stock futures showed signs of recovery, with slight gains in S&P 500 (ES00) and Nasdaq 100 (NQ00) futures. The yield on the 10-year Treasury continued to climb, reflecting ongoing pressure in the bond market. Additionally, the U.S. dollar surged against the Japanese yen after the Bank of Japan opted to keep interest rates unchanged.

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In summary, the Federal Reserve’s recent actions have introduced considerable uncertainty into financial markets. While the historical record provides insights into possible outcomes, the trajectory of economic data and Federal Reserve policy will ultimately dictate market dynamics in the coming months. Investors should brace for potential volatility while keeping an eye on seasonal trends that could support equities into year-end.

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