Investors are betting that the Fed will restart interest rate cuts in September, nine months after the last rate cut in December 2024. Analysts said such a long period of policy stagnation could be particularly beneficial to stocks, potentially prolonging and extending the rally.
A big source of support for optimism comes from historical data. Ryan Detrick, chief market strategist at Carson Group, posted on the social platform
Although it's difficult to pinpoint the cause, Detrick said in a phone interview that investor psychology may be a factor. "As the situation stabilizes, the Fed will return to more accommodative language. To some extent, your previous concerns about policy stagnation may be alleviated, and the stock market will return to its previous bull market trajectory."
This background may explain why investors reacted strongly to Federal Reserve Chairman Jerome Powell's speech last Friday. Powell said a rate cut may be justified given growing concerns about the health of the job market.
Mike Reynolds, vice president of investment strategy at Glenmede, said Powell's statement marked a subtle but significant shift: the market's focus has shifted from "whether the Fed will cut interest rates this year" to "how many times it may cut interest rates and the pace of the rate cuts."
According to data from CME Group's FedWatch tool, traders currently see an 85% chance that the Fed will cut its key interest rate by 25 basis points in September, up from 75% a week ago; at the same time, they see an 83.9% chance that the Fed will cut interest rates at least twice in the remaining three policy meetings this year.
U.S. stocks closed higher last week, with the Dow Jones Industrial Average (DJI) hitting a new all-time closing high, rising 1.5% for the week, the S&P 500 Index (SPX) rising 0.3%, and the Nasdaq Composite Index (COMP) falling 0.6%.
Potential Variables: What factors could upset this expectation?
Nonetheless, a number of economic data may still affect the final decision before the end of the Fed's next meeting on September 17. Investors this week will welcome the July personal consumption expenditures (PCE) index – the Fed's favored inflation measure; followed by the August non-farm payrolls report in early September; and on the eve of the September meeting, the latest consumer price index (CPI) and producer price index (PPI) data will also be released.
Powell has reminded the market that the Fed will still adhere to the principle of "data dependence", but analysts said that only a truly unexpected situation may change the current trend. "For the Fed to abandon plans to cut interest rates in September, it would probably take something completely unexpected, such as an unusually strong inflation report," Reynolds said on the call.
However, Reynolds believes that this situation is "extremely unlikely" at this time. "Current labor market problems appear to be more concerning than inflation. And given that interest rates are currently at mildly restrictive levels, combined with the balance of risks, we believe the Fed needs to move rates closer to neutral."
James Ragan, director of wealth management research at DA Davidson & Co., also agreed that a rate cut in September is highly likely. "I think it is unlikely that there will be too many factors that will change the expectation of a 25 basis point interest rate cut at the September meeting. Now the focus of discussion may turn to: Will there be a 50 basis point cut? What action will be taken in October?"
If the interest rate cut is finalized, which sectors will benefit?
Analysts said the stock market rally could spread beyond broad-market technology stocks to more sectors if the Federal Reserve cuts key policy rates. Falling interest rates typically prompt investors to move further up the risk curve in search of higher returns. Steve Sosnick, chief strategist at Interactive Brokers, said: "In general, assets with greater exposure are likely to perform better after interest rate cut expectations increase."
Reynolds noted that small-cap stocks in particular could benefit – such companies typically hold more floating-rate debt and are more sensitive to changes in borrowing costs. The Russell 2000, which tracks the 2,000 smallest companies in the Russell index, rose 3.9% on Friday, outpacing the S&P 500's 1.5% gain.
Reynolds added that growth stocks generally perform better in a low interest rate environment, but current valuations of growth stocks are already at high levels, and if earnings growth cannot keep up, their upside may be limited.
Risks ahead still exist
Despite the positive sentiment, not everyone believes the market rally can continue unimpeded. Sosnick warned that the market may now be in a "hyper state."
"How long can this go on? Will other Fed officials start expressing disapproval?" he said.
Opposition has actually emerged. Cleveland Fed President Beth Hammack said last week she was reluctant to support a rate cut in September based on current data. This highlights the differences within the Fed on the "pace of easing policy."
"There are a lot of other cross-over risks in the market right now, but right now, investor sentiment is very positive," Sosnick said.
