What will happen next week when the "US stocks that surged 32% in 5 months" meet the "Federal Reserve resuming interest rate cuts"?

Record-breaking US stocks face a turning point as the Federal Reserve is about to restart rate cuts, with the market caught in a tug-of-war between expectations of monetary easing and concerns over an economic slowdown.

Written by: Zhang Yaqi

Source: Wallstreetcn

After a $14 trillion surge, the soaring US stock market is approaching a critical turning point. The market expects the Federal Reserve to restart its rate-cutting cycle next week. However, when a bull market driven by central bank easing expectations encounters a deeper, trillion-dollar wave of passive investment, the traditional market playbook may no longer apply.

Since the lows in April, the S&P 500 index has soared 32%, fueled by expectations that the Federal Reserve will cut rates multiple times this year. The market has almost fully priced in a 25 basis point rate cut next Wednesday. Historical data seems to favor the bulls, but recent economic data—including employment reports—have sounded warning bells, sparking concerns about a potential “hard landing” for the economy. Investors are fiercely debating whether the Federal Reserve’s actions are coming too late.

The core of this debate over the market’s direction lies in the speed of the economic slowdown and the extent of monetary easing the Federal Reserve will need to implement. Traders’ bets not only affect asset prices but also determine investment strategies from tech giants to small companies.

Meanwhile, a profound structural shift may be undermining the traditional influence of the Federal Reserve’s monetary policy. A trillion-dollar wave of funds, guided by exchange-traded funds (ETFs), is continuously flowing into the market in “autopilot” mode, providing steady support for risk assets regardless of economic data. This phenomenon makes next week’s Federal Reserve decision even more complex: is the market cheering for policy easing, or is it simply running on its own powerful capital flow logic?

Economic and Market Tug-of-War Amid Rate Cut Expectations

At 2 p.m. next Wednesday, the world’s attention will focus on the Federal Reserve’s post-meeting statement, the latest interest rate “dot plot” forecasts, and Chairman Powell’s speech half an hour later. Data shows that interest rate swap contracts have fully priced in at least one 25 basis point rate cut, and expect a cumulative 150 basis points of cuts over the next year. If the Federal Reserve’s official outlook matches this, it will undoubtedly encourage stock market bulls.

History seems to be the optimists’ “friend.” According to data from Ned Davis Research dating back to the 1970s, when the Federal Reserve restarts rate cuts after pausing hikes for six months or longer, the S&P 500 index rises an average of 15% over the following year—outperforming the 12% average gain after the first cut in a typical rate-cutting cycle.

However, concerns are equally real. Although economic growth is currently relatively strong and corporate profits remain healthy, some ominous signs have emerged. An employment report showing the unemployment rate rising to its highest level since 2021 has heightened doubts. Sevasti Balafas, CEO of GoalVest Advisory, said:

“We are at a unique moment. The biggest unknown for investors is the extent of the economic slowdown and how much the Federal Reserve will need to cut rates. It’s tricky.”

Trillion-Dollar Capital Flows Reshape Market Logic

Traditionally, the Federal Reserve’s benchmark interest rate is the “commander-in-chief” of Wall Street’s risk appetite. But now, this logic is facing a severe test. Goldman Sachs CEO David Solomon said bluntly this week:

“When you look at the market’s risk appetite, you don’t feel that policy rates are particularly restrictive.”

The market’s performance confirms his view. So far this year, ETFs have absorbed over $800 billion in funds, with $475 billion flowing into stocks, on track to set a historic annual inflow record of over $1 trillion. Even during the market pullback in April, according to media compilations, ETFs still attracted $62 billion in inflows. Behind this is a structural force known as the “autopilot effect”: trillions of dollars in retirement savings are regularly and automatically invested into passive index funds through 401(k) plans, target-date funds, and model portfolios.

Vincent Deluard, global macro strategist at StoneX Financial, described it as:

“We have invented a perpetual motion machine. Regardless of valuations, market sentiment, or the macro environment, we put about 1% of GDP into index funds every month.”

This “inelastic demand” explains why inflows remain robust even when employment data is weak or the Fed hesitates. Market research also finds that when the Federal Reserve unexpectedly cuts rates, large-cap index funds tend to amplify gains; when rates are unexpectedly raised, they can cushion declines. The reason is mechanical: the creation and redemption process of ETFs moves a basket of stocks at once, amplifying demand during inflows and softening the impact during outflows.

The conclusion of this finding is: ETFs have become so central to market infrastructure that they can influence how monetary policy is transmitted in the market.

However, this seemingly permanent capital flow may also be fragile. JPMorgan strategist Nikolaos Panigirzoglou points out that risk markets won’t worry if rate cut expectations drop from 140 basis points to 120 basis points: “Only when the Federal Reserve signals that it won’t cut rates at all will they really start to worry.”

Investment Playbook: Sector Rotation During Rate-Cutting Cycles

Facing the upcoming rate cuts, investors are actively deploying their “trading playbooks,” and historical experience provides strategic references for different scenarios.

According to data compiled by Ned Davis Research strategist Rob Anderson, historical rate-cutting cycles show clear patterns. In cycles where the economy is strong and the Federal Reserve makes only one or two “precautionary” cuts after a pause, cyclical sectors such as financials and industrials perform best. In contrast, during cycles where the economy is weak and four or more significant rate cuts are needed, investors prefer defensive sectors, with healthcare and consumer staples delivering the highest median returns.

Stuart Katz, Chief Investment Officer at wealth management firm Robertson Stephens, says the market depends on three main factors: the speed and magnitude of Federal Reserve rate cuts, whether AI-driven trading can continue to drive growth, and whether tariff risks will trigger inflation. He believes that the unexpected drop in producer prices in August has eased inflation concerns, so he has been buying small-cap stocks sensitive to interest rates.

Other investors are focusing on different areas. Andrew Almeida, Director of Investments at XY Planning Network, favors mid-cap stocks. He believes that although this category is often overlooked, it typically outperforms large- and small-cap stocks in the year after rate cuts begin. He also favors financials and industrials, which benefit from lower borrowing costs.

Meanwhile, some investors are sticking with this year’s leading stocks. Sevasti Balafas of GoalVest Advisory continues to hold shares in Nvidia, Amazon, and Alphabet, betting that a gradual economic slowdown won’t derail these giants’ profit growth.

As Katz puts it:

“If growth slows, the Federal Reserve will cut rates, but if the economy stalls too quickly, the risk of recession rises. So, how much tolerance do investors really have for an economic slowdown? Time will tell.”