Investors Bet on Fed Rate Cuts, Potentially Boosting Stock Market Rally

Investors are wagering that the Federal Reserve will resume cutting interest rates in September, nine months after the last cut in December 2024. Analysts suggest that such a prolonged period of policy stagnation could be particularly beneficial for the stock market, potentially extending and amplifying the rally.

A major support for optimism stems from historical data. Carson Group's Chief Market Strategist, Ryan Detrick, pointed out on X that in 10 out of 11 instances where the Fed paused for 5 to 12 months and then cut rates again, the S&P 500 Index rose in the following year.

While the exact reason is difficult to pinpoint, Detrick said in a phone interview that investor psychology could be a factor. "As the situation gradually stabilizes, the Fed will revert to using more dovish language. To some extent, your previous concerns about policy stagnation may ease, and the stock market will return to its previous bull market trajectory."

This might explain why investors reacted strongly to Fed Chair Jerome Powell's remarks last Friday. Powell suggested that rate cuts could be justified, given growing concerns about the health of the labor market.

Glenmede's Vice President of Investment Strategy, Mike Reynolds, stated that Powell's statement marked a subtle but significant shift: the market's focus has moved from "whether the Fed will cut rates this year" to "how many times rates might be cut, and at what pace."

According to data from the CME FedWatch Tool, traders currently anticipate an 85% probability that the Fed will lower the key interest rate by 25 basis points in September, up from 75% a week earlier. Simultaneously, they believe there's an 83.9% chance that the Fed will cut rates at least twice during the remaining three policy meetings this year.

US stocks closed higher last week, with the Dow Jones Industrial Average (DJI) hitting a record closing high, gaining 1.5% cumulatively for the week. The S&P 500 Index (SPX) rose 0.3%, while the Nasdaq Composite Index (COMP) declined 0.6%.

Potential Variables: What Factors Could Break This Expectation?

Nevertheless, several economic data releases before the Fed's next meeting on September 17th could still influence the final decision. Investors will receive the July Personal Consumption Expenditures (PCE) index this week – the Fed's preferred inflation gauge. In early September, the August non-farm payroll report will be released. And just before the September meeting, the latest Consumer Price Index (CPI) and Producer Price Index (PPI) data will be published.

Powell has cautioned the market that the Fed will remain committed to the principle of being "data-dependent," but analysts say that only a genuinely unexpected event is likely to alter the current trajectory. Reynolds said in a phone call: "For the Fed to abandon its plan to cut rates in September, something completely unexpected would likely need to occur, such as an unusually strong inflation report."

However, Reynolds believes this scenario is "highly unlikely" at present. "The current labor market issues seem more concerning than inflation. And given that current interest rates are at a moderately restrictive level, coupled with the risk balance, we believe the Fed needs to bring rates closer to a neutral level."

James Ragan, Director of Wealth Management Research at D.A. Davidson & Co., also agrees that a September rate cut is highly probable. "I don't think there's likely to be much that will change the expectation of a 25-basis-point rate cut at the September meeting, and the focus may now shift to: will there be a 50-basis-point decrease? And what will happen in October?"

If Rates Are Cut, Which Sectors Will Benefit?

Analysts say that if the Fed lowers key policy rates, the stock market rally could spread from large-cap tech stocks to more sectors. Lower interest rates typically prompt investors to move further out on the risk curve in search of higher returns. Interactive Brokers' Chief Strategist, Steve Sosnick, said: "Overall, as rate cut expectations rise, riskier assets are likely to perform better."

Reynolds points out that small-cap stocks could be particularly beneficial – these companies typically hold more floating-rate debt and are more sensitive to changes in borrowing costs. The Russell 2000 Index, which tracks the smallest 2,000 companies in the Russell Index, rose 3.9% last Friday, outperforming the S&P 500 Index's 1.5% gain.

Reynolds added that in a low-interest-rate environment, growth stocks typically perform better, but growth stocks are currently valued at high levels, and if earnings growth cannot keep pace, their upside potential may be limited.

Risks Remain Ahead

Despite optimistic market sentiment, not everyone believes the market rally can continue unimpeded. Sosnick warned that the market may currently be in a state of "euphoria."

"How long can this state last? Will other Fed officials begin to express opposition?" he said.

Opposing voices have already emerged. Cleveland Fed President Beth Hammack said last week that, based on available data, she would be unwilling to support a rate cut in September. This highlights a division within the Fed regarding the "pace of easing policy."

"The market currently faces many other cross-risks, but for now, investor sentiment is very optimistic," Sosnick said.