A rate cut by the Federal Reserve on Wednesday is all but certain. However, there is still uncertainty about how the stock market might react as the central bank eases monetary policy.

History offers some guidance: The reasons why the Fed cuts rates are far more important to markets than the simple fact that borrowing costs have fallen.

A chart by Vickie Chang, a macro strategist at Goldman Sachs (GS.N), shows that the Fed has eased monetary policy 10 times since the mid-1980s.

Four of the cycles were associated with recessions, and six were not. When the Fed succeeds in averting a recession, stocks tend to rise; when it fails, they tend to fall.

Investors may not get all the information they need by Wednesday. How the stock market reacts will depend on what data reveals in the coming months.

“Whether this rate-cutting cycle will turn out to be a ‘growth scare’ or a ‘recession’ experience is the main question for the market,” Chang said in a note.

According to the median scenario, a rate-cutting cycle during a recession causes the S&P 500 to fall 10% in the first six months.

What will Wednesday's rate cut send to investors about the economy?

Still, the magnitude of Wednesday’s rate cut is likely to have a big impact on how investors think about the economy and could set the tone for markets for the rest of the year.

Investors are particularly eager for more guidance today, in part because the latest U.S. economic data looked somewhat murky. The Labor Department report showed a slowdown in hiring even as more workers entered the labor force.

Yet layoffs haven’t picked up significantly, at least not yet. Meanwhile, inflation has eased somewhat, but new data released this week suggest that prices for key services, such as rent and housing costs, remain somewhat sticky.

Investor confidence in the economy helped drive stock market gains in 2024, but that confidence has been shaken somewhat recently.

At times, concerns about a potential snowball effect from rising unemployment have outweighed the stock market’s performance, leading to painful sell-offs in August and September.

Is the Fed behind the economic cycle?

Some believe that the Fed is already behind the economic cycle and should have cut rates in July, so many on Wall Street expect a 50 basis point rate cut to trigger a negative reaction in the stock market.

Shannon Saccocia, chief investment officer of Neuberger Berman Private Wealth, told MarketWatch: “If they cut by 50 basis points, it means they (the Fed) made a mistake in July and are behind the economic cycle, or the data they have is worse than what we are seeing. This will cause more disturbance to the stock market.”

That uncertainty could keep stocks from selling off early, regardless of what the Fed does, according to a team of strategists at Deutsche Bank. As of early Friday, the market could be in for its biggest surprise in 15 years, regardless of the Fed’s choice, the team said.

In addition to the extent of the rate cut, the latest Fed economic forecasts should also be closely scrutinized.

The Fed will likely need to revise up its unemployment rate forecast while lowering its GDP growth expectations, John Velis, currency and macro strategist at BNY, said in emailed comments.

He said this does not necessarily mean the central bank is expecting a recession. But investors should still be wary of this because it could affect the market's expectations for how deep the Federal Reserve will cut interest rates.

Although the data has yet to show clear signs of a recession, investors still have plenty of reasons to be concerned.

Achieving a soft landing for the economy after such significant inflation would be a legendary feat for Fed Chairman Jerome Powell. According to Diane Swonk, chief U.S. economist at KPMG, such an achievement would be unprecedented.

The Fed has successfully pulled the economy back from the brink of crisis before, although strong post-pandemic inflation has added new complexities.

The series of rate cuts that began in 1995 was an example of how the Fed managed to pull off a "mid-cycle adjustment" without hurting markets, said Jurrien Timmer, director of global macro at Fidelity.

“It’s the exception rather than the rule. But it’s achievable,” Timmer told MarketWatch in an interview.

Article forwarded from: Jinshi Data