Historically, when the Federal Reserve has remained inactive for an extended period before cutting interest rates again, U.S. stocks are likely to rise the following year. However, the key data prior to the September meeting and the internal divisions within the Federal Reserve remain variables.
Investors are betting that the Federal Reserve will restart interest rate cuts in September, marking nine months since the last cut in December 2024. Analysts suggest that such an extended period of policy stagnation could particularly benefit the stock market, potentially prolonging and amplifying its upward momentum.
A significant support for the optimistic sentiment comes from historical data. Ryan Detrick, Chief Market Strategist at Carson Group, pointed out in a post on social platform X that in the past 11 instances where the Federal Reserve paused for 5 to 12 months before cutting rates again, 10 of them$S&P 500 Index (.SPX.US)$experienced an increase within a year after the rate cut.
Although it is difficult to pinpoint the exact reasons, Detrick indicated in a telephone interview that investor sentiment could be one influencing factor. "As the situation stabilizes, the Federal Reserve will likely revert to more accommodative language. To some extent, your previous concerns about policy stagnation may ease, and the stock market could return to its prior bullish trajectory."
This context may explain why investors reacted strongly to Federal Reserve Chair Jerome Powell's remarks last Friday. Powell stated that, given the growing concerns about the health of the job market, a rate cut could be a reasonable action.
Mike Reynolds, Vice President of Investment Strategy at Glenmede, remarked that Powell's statement signifies a subtle yet significant shift: the market's focus has shifted from "Will the Federal Reserve cut rates this year?" to "How many times might they cut rates, and what will the pace be?"
According to data from the CME FedWatch Tool, traders currently estimate an 85% probability that the Federal Reserve will lower the key interest rate by 25 basis points in September, up from 75% a week ago; they also believe there is an 83.9% probability that the Fed will cut rates at least twice in the remaining three policy meetings of this year.
The U.S. stock market closed higher last week, with the Dow Jones Industrial Average (DJI) reaching a record closing high, up 1.5% for the week, while the S&P 500 Index (SPX) rose 0.3%,$Nasdaq Composite Index (.IXIC.US)$(COMP) declined by 0.6%.
Potential Variables: What factors could disrupt this expectation?
Nevertheless, several economic data points may influence the final decision before the Federal Reserve's next meeting on September 17. Investors will receive the July Personal Consumption Expenditures (PCE) index—an inflation metric favored by the Federal Reserve—this week; subsequently, the August non-farm payroll report will be released in early September; and just before the September meeting, the latest Consumer Price Index (CPI) and Producer Price Index (PPI) data will be published.
Powell has reminded the market that the Federal Reserve will continue to adhere to a "data-dependent" approach, but analysts state that only a truly unexpected situation could alter the current trend. Reynolds mentioned in a phone call, "To convince the Federal Reserve to abandon its plan for a rate cut in September, something completely unexpected would likely be required, such as an exceptionally strong inflation report."
However, Reynolds believes that the likelihood of such a scenario currently is "extremely low." "The issues in the labor market seem to be more concerning than inflation. Moreover, considering that current interest rates are at a moderately restrictive level, combined with the risk balance, we believe the Federal Reserve needs to bring rates closer to neutral levels."
James Ragan, head of wealth management research at D.A. Davidson & Co., also agrees that the probability of a rate cut in September is very high. "I think it is unlikely that many factors will change the expectation of a 25 basis point rate cut at the September meeting; the focus of the discussion now may shift to: Will there be a 50 basis point cut? What actions will be taken in October?"
If a rate cut is confirmed, which sectors will benefit?
Analysts indicate that if the Federal Reserve lowers its key policy interest rate, the stock market's upward momentum may spread from major technology stocks to a broader range of sectors. A decrease in interest rates typically encourages investors to move further along the risk curve in search of higher returns. Steve Sosnick, Chief Strategist at IB, stated: "Overall, as expectations for interest rate cuts rise, assets with greater risk exposure may perform better."
Reynolds pointed out that small-cap stocks might benefit particularly—these companies typically hold more floating-rate debt and are more sensitive to changes in borrowing costs. TrackingRussell Indexthe 2,000 smallest companies in ChinaRussell 2000 Indexrose 3.9% last Friday, exceeding the 1.5% increase of the S&P 500 Index.
Reynolds added that growth stocks typically perform better in a low interest rate environment, but currently their valuations are at high levels, and if earnings growth cannot keep pace, their upside potential may be limited.
Risks ahead remain
Despite the optimistic market sentiment, not everyone believes that the market's upward trend can continue without obstacles. Sosnick warned that the market may currently be in a "frenzied state."
"How long can this state last? Will other Federal Reserve officials begin to express dissent?" he said.
Opposing voices have already emerged. Last week, Beth Hammack, President of the Cleveland Federal Reserve, stated that based on existing data, she is unwilling to support a rate cut in September. This highlights the divergence within the Federal Reserve regarding the "pace of easing policy."
"Currently, the market faces many other cross risks, but for the time being, investor sentiment is very optimistic," said Sosnick.
Editor/Rocky