Investors are betting the Federal Reserve will resume interest-rate cuts in September, nine months after its last reduction in December 2024. Such a long pause could be particularly bullish for equities, potentially extending and broadening the stock market’s rally, analysts said. 

One reason for optimism lies in history. Ryan Detrick, chief market strategist at Carson Group, noted in a post on X that the S&P 500 has rallied in the year following 10 out of the past 11 times when the Fed waited between five and 12 months before cutting rates again.

While the cause is hard to pinpoint, Detrick suggested investor psychology may be a factor. “As the ship is righted, and you can get back to the more dovish language from the Fed. Maybe some of those worries that you had over the pause have been alleviated, and it got back to your previously scheduled bull market, in a way,” he said in a phone interview.

That backdrop may help explain why investors reacted so strongly to Fed Chair Jerome Powell’s comments on Friday. Powell signaled that a rate cut may be warranted given growing concern about the health of the job market.

His remarks marked a subtle but meaningful shift. Instead of asking whether the Fed will cut rates this year, markets are now focused on how many times it might ease, and at what pace, said Mike Reynolds, vice president of investment strategy at Glenmede.

Traders are now pricing in an 85% chance that the Fed will cut its key interest rate by 25 basis points in September, up from 75% a week ago, according to the CME FedWatch tool. They also see an 83.9% likelihood that the Fed will deliver at least two rate cuts this year, with three policy meetings remaining.

U.S. stocks finished the week higher, with a Friday rally lifting the Dow Jones Industrial Average to a record close. The Dow gained 1.5% for the week, while the S&P 500 rose 0.3% while the Nasdaq Composite slipped 0.6%.

Could anything derail the conviction? 

Even so, several economic reports could shape the final decision before the Fed’s next meeting concludes on Sept. 17. Investors will see July’s personal consumption expenditures index, the central bank’s preferred inflation gauge next week, followed by the August jobs report in early September. Then new data on consumer prices and producer prices will arrive right before the September meeting. 

Powell reminded markets that the central bank remains data-dependent, but analysts say it would take a real surprise to change the trajectory. “We probably have to see something really out of left field to knock the Fed off track for a rate cut for September. That may look like an exceptionally hot inflation report,” Reynolds said in a call. 

However, that is a “pretty low likelihood” at this point, Reynolds said. “The labor market side of the equation is looking a little bit more worrying than inflation right now. And given rates are at a modestly tight level, we think the Fed needs to get that closer to neutral, given the balance of risks,” according to Reynolds.

James Ragan, director of wealth management research at D.A. Davidson & Co., agreed that the odds strongly favor a September cut. “I think there’s probably not a whole lot that’s going to change that 25-basis-point cut at the September meeting, and the discussion will shift now to, could it be 50 basis points, or what will happen in October?” said Ragan.

A broadening rally

If the Fed does cut its key policy rate, analysts expect the rally in equities to spread beyond its leadership in large-cap tech. Lower rates often drive investors further out on the risk curve in search of higher returns. “In general, the further out one is on the risk curve, the better the asset could be doing after the expectation of the rate cut jumps,” said Steve Sosnick, chief strategist at Interactive Brokers.

Small-cap stocks, in particular, may benefit because such companies typically carry more floating-rate debt, making them more sensitive to changes in borrowing costs, noted Reynolds. The Russell 2000, which tracks the 2,000 smallest companies in the Russell index, jumped 3.9% on Friday, outpacing the S&P 500’s 1.5% gain.

Growth stocks also tend to outperform in a low-rate environment, though Reynolds noted their valuations are already stretched, which could limit upside if earnings don’t keep pace, Reynolds added. 

Risks ahead 

Despite the optimism, not everyone is convinced the rally can continue uninterrupted. Sosnick warned that markets may already be in an “euphoria state.” 

“How long does that persist? And do we start to get to see pushback from some of the other members of the Federal Reserve?,” he said.

That pushback is already visible. Cleveland Fed President Beth Hammack said on Thursday she would not be willing to cut rates in September based on the data available, highlighting divisions inside the Fed about how quickly to ease policy.

“There are plenty of other cross currents out there, but for now the market is just in a very happy frame of mind,” Sosnick said.