After the Fed's Big Rate Cut, Investors Cheer for a Soft Landing. But They’re Still Keeping Their Guard Up for a Downturn.

The Federal Reserve finally responded to stock-market demands by lowering interest rates for the first time since March 2020, a move that has increased the likelihood of a soft landing for the U.S. economy as inflation shows signs of cooling.

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For over a year, the Fed held its benchmark interest rate at 5.25% to 5.5%, resisting calls to lower it. However, at its policy meeting on September 18, the central bank decided to cut rates by half a percentage point, a larger reduction than many expected. Leading up to the meeting, investors were unsure whether the cut would be 25 or 50 basis points. By choosing the more significant 50 basis point cut, the Fed sent a strong message that it was prepared to take whatever steps were necessary to support economic growth and stave off a potential labor market slowdown.

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Still, some investors are questioning whether this rate cut will indeed ensure a soft landing—where inflation is controlled without sharply slowing economic growth—or if it highlights that the Fed may have been slow in taking action to prevent a recession.

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Following the rate cut announcement, markets responded positively, with stocks surging the next day. The Dow Jones Industrial Average rose 1.3%, the S&P 500 gained 1.7%, and the Nasdaq Composite grew by 2.5%. Both the Dow and S&P 500 closed at record highs. While rate cuts typically boost stock prices on their own, the certainty provided by this first rate cut seemed to offer an additional push. Investors were reassured, knowing when the cuts would happen and the magnitude of those cuts.

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“The market doesn’t like uncertainty, and that uncertainty was removed yesterday,” Bill Merz, head of capital markets research at U.S. Bank Wealth Management, told MarketWatch the day after the Fed’s decision. He added that the Fed’s policy had shifted to a more accommodative stance, further comforting the market.

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Merz explained that with the Fed adopting this more accommodating approach, investors were beginning to price in a higher likelihood of a soft landing. At the same time, they were not entirely ignoring risks. The higher valuations and robust performance across both cyclical growth stocks and defensive sectors suggest a cautious optimism. Merz pointed out that this “natural hedging” reflects investors’ belief in the long-term growth potential of the U.S. economy while preparing for possible short-term economic slowdowns.

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“The market is leaning towards the outcome of a softer landing, but it is also acknowledging that risks remain. Growth is decelerating, the labor market is cooling, and it’s unclear exactly where these trends will settle,” Merz observed.

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The Fed’s decision to implement a larger rate cut has shifted the narrative toward a soft landing and highlighted the central bank’s willingness to act. During the Federal Open Market Committee (FOMC) meeting, Fed chair Jerome Powell emphasized that the Fed is committed to doing what is necessary to boost the economy. “You can take this as a sign of our commitment not to get behind,” Powell said, signaling the central bank’s intent to stay proactive.

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This assurance has fueled optimism about the possibility of avoiding a recession. JoAnne Bianco, a partner and investment strategist at BondBloxx, echoed this sentiment. She noted that the Fed’s determination to remain ahead of the curve increases the chances that the U.S. can avoid a significant downturn or prolonged economic slowdown.

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Despite the positive market response, the recent rally in defensive stocks suggests that investors are still hedging against potential risks. Some remain wary that a growth scare could occur, particularly if data shows signs of economic deceleration. For example, the market reacted negatively to rising unemployment in early August, highlighting investor sensitivity to any hints of economic weakness.

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A further slowdown in consumer spending or a deeper cooling of the labor market could spook investors and lead to renewed market volatility. Although Powell downplayed this risk, stating, “I don’t see anything in the economy right now that suggests that the likelihood of a downturn is elevated,” the possibility of a growth scare cannot be entirely dismissed.

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The Fed’s reassuring tone about the economy could raise the threshold for what might trigger panic among investors. However, some still fear that a resurgence in inflation could undermine the current optimistic outlook. Thomas Urano, managing partner and co-chief investment officer at Sage Advisory, warned that if inflation ticks up, the market’s positive view on the economy could change quickly.

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“I think everyone believes inflation is softening, and the Fed is working hard to prevent unemployment from spiraling. But if inflation rises again, the market might have to rethink that,” Urano explained. He added that a scenario of stagflation—where inflation rises while unemployment also increases—would be the worst-case scenario for the Fed’s dual mandate of maintaining price stability and maximizing employment.

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For now, both the Fed and market observers like Urano don’t expect inflation to rise significantly. “That’s one of the least likely outcomes,” Urano said. However, he cautioned that if inflation does pick up, the Fed might have to accept a recession and higher unemployment to combat rising prices.

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In conclusion, it’s still too early to determine whether the Fed’s rate cut will successfully engineer a soft landing or if it will be seen as too little, too late in hindsight. “There’s no referee on the field who’s going to declare a soft landing or call a recession flag in real time,” Urano remarked, highlighting the challenge of central bank policy. Nonetheless, for now, the Fed’s decision has injected a dose of optimism into the market.

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