What will happen next week when the “U.S. stock market surged 32% in 5 months” meets the “Federal Reserve that resumed interest rate cuts”?

The U.S. stock market, having surged 32% since April, faces a pivotal test as the Federal Reserve is widely expected to resume interest rate cuts next week. While history suggests stocks tend to rise after the Fed ends a pause and starts cutting, the current environment is complicated by warning signs in economic data and a structural shift in market dynamics.

Fed Decision & Economic Crossroads: Markets have fully priced in a 25 basis point cut, with expectations of ~150 bps in total cuts over the next year. However, a rising unemployment rate has intensified the debate on whether the Fed is acting too late to avoid a hard landing.
The "Autopilot" Capital Flow: A powerful, structural force is reshaping market logic. Over $475 billion has flowed into stock ETFs this year, driven by passive investment vehicles like 401(k)s. This creates consistent, valuation-insensitive demand that supports asset prices regardless of economic data or Fed policy, potentially muting the traditional impact of interest rate changes.
Investor Strategies: Historical patterns show sector performance varies with the depth of the rate-cut cycle. Investors are positioning accordingly:
- Some favor cyclical sectors like financials and industrials if the economy remains strong and cuts are minimal ("insurance cuts").
- Others are betting on rate-sensitive small and mid-cap stocks, which historically outperform after cuts begin.
- Many are holding onto AI-driven tech giants, betting their earnings can withstand a gradual slowdown.

The market's final direction hinges on the complex contest between the Fed's policy signals, the actual pace of the economic slowdown, and the relentless flow of passive capital.

Written by Zhang Yaqi, Wall Street Journal

After a $14 trillion surge, the high-flying U.S. stock market is reaching a critical inflection point. Markets anticipate the Federal Reserve will resume its interest rate cut cycle next week. However, when a bull market driven by expectations of central bank easing meets a deeper, trillion-dollar wave of passive investment, the traditional market playbook may no longer apply.

Since its April low, the S&P 500 has surged 32%, driven by expectations that the Federal Reserve will cut interest rates multiple times this year, with a quarter-point rate cut next Wednesday almost fully priced in. Historical data appears to be on the bulls' side, but recent economic data, including the jobs report, has flashed warning lights, raising concerns about the risk of a "hard landing" for the economy, and investors are fiercely debating whether the Fed's actions are too late.

At the heart of the market debate is the pace of the economic slowdown and how aggressively the Federal Reserve needs to ease policy to counter it. Traders’ bets influence not only asset prices but also investment strategies for companies ranging from tech giants to smaller firms.

At the same time, a profound structural shift may be weakening the traditional influence of the Federal Reserve's monetary policy. A trillion-dollar wave of funds, led by exchange-traded funds (ETFs), continues to pour into the market on autopilot, providing stable support for risky assets regardless of good or bad economic data. This phenomenon complicates next week's Fed decision: Is the market cheering policy easing, or is it operating under its own powerful capital flow logic?

Economic and market competition under the expectation of interest rate cuts

At 2:00 PM next Wednesday, global markets will be focused on the Federal Reserve's post-meeting statement, its updated interest rate projections ("dot plot"), and Chairman Powell's speech half an hour later. Data indicates that interest rate swaps are fully priced in at least one 25 basis point rate cut, with projections of approximately 150 basis points of cumulative rate cuts over the next year. If the Fed's official outlook matches this, it will undoubtedly encourage stock market bulls.

History seems to be a friend of optimists. According to data from Ned Davis Research dating back to the 1970s, when the Federal Reserve resumed rate cuts after pausing for six months or more, the S&P 500 rose an average of 15% in the following year. This outperforms the average 12% gain after the first rate cut in a typical rate-cutting cycle.

However, concerns are also real. Despite relatively strong economic growth and healthy corporate profits, some ominous signs have emerged, and a jobs report showing the unemployment rate rising to its highest level since 2021 has exacerbated people's doubts. Sevasti Balafas, CEO of GoalVest Advisory, said:

“We’re in a unique moment where the biggest unknown for investors is how deep the economic slowdown will be and how much the Fed will need to cut rates. It’s tricky.”

Trillion-dollar capital flows reshape market logic

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

“When you look at the risk appetite in the market, you don’t see the policy rate as being very restrictive.”

Market performance confirms his view. So far this year, ETFs have attracted over $800 billion, with $475 billion flowing into the stock market, putting them on track to set a record for annual inflows exceeding one trillion dollars. Even during the April market correction, ETFs attracted $62 billion in inflows, according to data compiled by media outlets. This is driven by a structural force known as the "autopilot effect": trillions of dollars in retirement savings are regularly and automatically invested in passive index funds through 401(k) plans, target-date funds, and model portfolios.

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

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

This "inelastic demand" explains why fund inflows remain strong even when employment data weakens or the Fed hesitates. Market research also finds that broad-market index funds tend to amplify gains when the Fed unexpectedly cuts interest rates, while cushioning losses during unexpected rate hikes. The reason is mechanistic: the subscription and redemption process of ETFs moves a basket of stocks at once, amplifying demand during inflows and mitigating the impact during outflows.

This finding concludes that ETFs have become so central to market infrastructure that they can influence how monetary policy is transmitted through the market.

However, this seemingly permanent flow of funds may also be fragile. Nikolaos Panigirzoglou, a strategist at JPMorgan Chase, pointed out that risk markets will not be bothered by the change in rate cut expectations from 140 basis points to 120 basis points. "They will only really worry if the Fed signals that it will not cut rates at all."

Investment Playbook: Sector Rotation During the Rate Cut Cycle

Faced with the upcoming interest rate cut, investors are actively deploying their own "trading scripts", and historical experience provides strategic references under different scenarios.

According to data compiled by Rob Anderson, a strategist at Ned Davis Research, historical rate-cutting cycles exhibit a clear pattern. Cyclical sectors such as financials and industrials perform best during periods of economic strength and when the Fed only implements one or two "insurance" rate cuts after a pause. Conversely, during periods of economic weakness and the need for four or more significant rate cuts, investors favor defensive sectors, with healthcare and consumer staples delivering the highest median returns.

Stuart Katz, chief investment officer at wealth management firm Robertson Stephens, said the market hinges on three key factors: the speed and depth of the Federal Reserve's rate cuts, whether AI deals can continue to drive growth, and whether tariff risks will stoke inflation. He believes an unexpected drop in producer prices in August has eased inflation concerns, so he has been buying interest-rate-sensitive small-cap stocks.

Other investors are looking at different sectors. Andrew Almeida, investment director at XY Planning Network, favors mid-cap stocks, arguing that while this often overlooked category typically outperforms both large- and small-cap stocks in the year following the start of rate cuts . He also favors financial and industrial sectors, which benefit from lower borrowing costs.

Meanwhile, some investors are holding on to this year's top gainers. Sevasti Balafas of GoalVest Advisory is holding onto shares of Nvidia, Amazon, and Alphabet, betting that a gradual economic slowdown won't derail their earnings growth.

As Katz puts it:

"If growth slows, the Fed will cut rates, but if the economy loses momentum too quickly, recession risks will rise. So, how much tolerance will investors have for an economic slowdown? Time will tell."