After 9 months on hold, the Fed could cut rates in September. Why the long pause may extend stocks' rally.

Investors are now highly confident the Federal Reserve will implement a 25 basis point rate cut in September, ending a nine-month pause, following Fed Chair Powell's recent dovish shift on the job market and historical precedents suggesting equity rallies after similar long pauses. With CME FedWatch pricing an 83% probability, this anticipated easing is expected to extend and broaden the equity market rally, particularly benefiting small-cap stocks sensitive to borrowing costs. While upcoming economic data remains crucial, analysts believe only a significant inflation surprise could derail the September cut, despite some emerging internal Fed dissent.

Analysis

Market conviction for a Federal Reserve rate cut in September has solidified, driven by Fed Chair Jerome Powell's dovish pivot regarding the labor market. Traders are pricing in an 83% probability of a 25 basis point cut, according to the CME FedWatch tool, marking a significant shift from a week prior. This expectation is underpinned by historical analysis from Carson Group, which notes that the S&P 500 has rallied in 10 of the last 11 instances following a Fed pause of five to twelve months. The market's reaction has been overtly positive, with the Dow Jones reaching a record close and the Russell 2000's 3.9% single-day jump on Friday suggesting the rally is broadening beyond large-cap tech. Analysts anticipate small-cap stocks will be primary beneficiaries due to their sensitivity to borrowing costs via floating-rate debt. While the outlook is bullish, risks remain. The Fed's decision is still data-dependent, hinging on upcoming reports like the PCE index and jobs data, though analysts believe only an 'exceptionally hot' report would derail the cut. Furthermore, internal dissent is visible, with Cleveland Fed President Beth Hammack expressing unwillingness to cut, and strategists like Steve Sosnick of Interactive Brokers cautioning that markets may be in a state of 'euphoria'.

Key Decisions for Investors

• Given the high probability of a September rate cut and the strong performance of small-caps, investors should evaluate rotating capital into this segment, which is poised to benefit from lower borrowing costs.
• Closely monitor the upcoming July Personal Consumption Expenditures (PCE) index and the August jobs report, as an unexpectedly strong inflation or labor market reading represents the primary identified risk that could alter the Fed's September trajectory.
• Despite the strong positive sentiment, be mindful of potential market 'euphoria' and emerging dissent within the Fed by reviewing portfolio risk levels, as any hawkish surprise could temper the ongoing rally.