The Rally in Stocks Built on Hopes of More Rate Cuts from the Fed Faces a Crucial Test

Investors received a big boost when the Federal Reserve implemented a larger-than-expected interest rate cut in September, something many had been hoping for. However, there’s now concern that upcoming strong jobs data could present a new challenge for Wall Street.

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According to Komal Sri-Kumar, president of Sri-Kumar Global Strategies, if the jobs report for the upcoming week reveals robust employment numbers, it could unsettle the equity markets. He explained that stronger-than-expected data could prompt investors to rethink their expectations for further interest rate cuts, which have been driving market optimism.

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‍Much of this revolves around how investors view future interest rate cuts. If the economic data points to strength, investors may reduce their expectations for more monetary easing by the Federal Reserve. This shift could lead to a scenario where good economic news translates into bad news for stock prices. This dynamic, where positive economic indicators dampen market sentiment, has played out before, leaving market participants feeling whipsawed by the shifting expectations.

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Throughout the lead-up to the Federal Reserve’s decision on September 18, many analysts and investors feared the central bank was falling behind the curve. There had been earlier concerns about economic growth, particularly in late July and early August, when recession fears and worries about a labor market downturn weighed on sentiment. The idea was that an economic slowdown could lead to a decline in corporate earnings, further pressuring the stock market.

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The Fed’s decision to implement a 50-basis-point cut in interest rates, rather than the expected 25-basis-point reduction, helped to ease some of these concerns about a looming recession. However, it also reignited fears that inflation might not fall back to the central bank’s target of 2% as quickly as hoped. Following the decision, market-based measures of inflation expectations began to rise, pushing short- and long-term Treasury yields higher.

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‍Andrea Cicione, head of strategy at TS Lombard, pointed out that aggressive rate cuts may paradoxically prevent bond yields from falling further. Cicione noted that the Federal Reserve’s approach could encourage markets to factor in the possibility of a rebound in both growth and inflation next year. This, in turn, could lead to higher risk premiums and expectations of more rate hikes in the next economic cycle.

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Despite some signs of increasing inflation expectations, Sri-Kumar noted that stock-market investors haven’t shown significant concern about a potential rise in inflation just yet. In fact, inflation can often benefit companies that are able to pass higher prices on to their customers. However, he warned that if strong jobs data leads investors to revise their expectations for rate cuts, the mood in the market could shift.
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‍Sri-Kumar has been critical of the Federal Reserve’s decision to start its rate-cutting cycle with such a large move. He believes that the Fed’s 50-basis-point cut in September was designed to please stock-market participants. Fed Chair Jerome Powell, during his post-meeting press conference, managed to convince investors that the cut was not a sign of panic over the economic outlook but rather a response to declining inflation. However, Sri-Kumar believes that the Fed’s decision “let the genie out of the bottle,” conditioning the market to expect more aggressive easing going forward. This means that policymakers could risk disappointing the market if they don’t deliver on these expectations.

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In the wake of the rate cut, stocks saw gains. The Dow Jones Industrial Average ended the week with a record close, while the S&P 500 pulled back slightly after hitting a record the day before. The Nasdaq Composite also posted a solid weekly gain of over 2%. These gains were partly driven by inflation data, as the personal consumption expenditures (PCE) index—the Fed’s preferred inflation gauge—came in slightly lower than expected for August, showing a year-over-year increase of 2.2%.

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On Monday, U.S. stock-index futures dipped slightly. Meanwhile, traders in the futures market were pricing in a roughly 55% chance of another 50-basis-point rate cut by the Fed in November, with a 45% chance of a smaller 25-basis-point cut. Investors are also largely expecting a total of 75 basis points in rate cuts by the end of the year, with the Fed’s next meetings scheduled for November and December.

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‍Powell has made it clear that the Fed’s primary focus now is on preventing further deterioration in the labor market, as inflation seems to be heading back toward the 2% target. The labor market has shown signs of cooling, with the U.S. economy adding fewer jobs in the three months from June to August than at any point since the pandemic. Hiring is not expected to accelerate significantly in the near term.

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Economists expect that the September jobs report will show an increase of 144,000 in nonfarm payrolls, up from 142,000 in August and 89,000 in July. The unemployment rate is projected to remain steady at 4.2%. This report, along with October’s jobs data, will give the Fed more information before its next policy meeting in November.

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Krishna Guha, head of global policy and central-bank strategy at Evercore ISI, noted that the September jobs report will be critical in determining whether the Fed opts for a 25- or 50-basis-point rate cut in November. While the Fed will have two jobs reports before that meeting, the second one will come just days before the decision.

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A strong jobs report on Friday might not cause too much concern for investors, given recent benchmark revisions and weakening hiring demand. However, if payrolls come in below 75,000 and unemployment rises to around 4.3% or 4.4%, the market could price in faster monetary easing.

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Ultimately, the labor market remains the central issue. If the jobs report shows significant weakness, it could be viewed as a “bad news is bad news” scenario, further complicating the outlook for both the economy and markets.

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In the meantime, investors will be paying attention to other economic data, including job openings and the Institute for Supply Management’s manufacturing index. Powell’s remarks at an economics conference on Monday could also offer further insights into the Fed’s thinking.

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For now, a jobs report that aligns closely with expectations might be the best outcome for investors, as it would avoid disrupting current monetary policy expectations.

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