The Fed should not cut interest rates too late or too early, unexpected early cuts may trigger market volatility

Investors are eager for the Fed to start cutting interest rates in September, but if the central bank unexpectedly cuts rates this Wednesday, the market may not necessarily be pleased.

According to the Wise Finance app, Rob Haworth, senior investment strategist at Bank of America, said in an interview, "If the Fed takes action without market expectations, it could cause some problems." He pointed out that this could lead to a stock market decline and a sell-off of U.S. Treasuries, as investors would accelerate expectations of future rate cuts.

Although rate cut expectations have played a significant role in the bull market in the U.S. stock market, Haworth noted that if a rate cut is not telegraphed in advance by policymakers, investors may interpret it as a "departure from convention" and worry about larger issues in the economy or financial system.

According to the CME FedWatch tool, federal funds futures traders believe there is less than a 5% chance of a rate cut at the end of the two-day policy meeting on Wednesday. Instead, the market is fully expecting the Fed to cut rates by at least 25 basis points at the September meeting.

So why discuss a rate cut on Wednesday? Some economists, including former Fed officials, believe a rate cut should have already happened. Former New York Fed President William Dudley stated in his widely followed column that weak economic data has proven that the July rate cut was justified, a shift from his previous stance of maintaining higher rates.

Former Fed Vice Chairman Alan Blinder pointed out in an article that the market widely expects a rate cut in September, but with current funding strains, the Fed is "squeezing" the U.S. economy. He sees a high likelihood of a rate cut in September, but also suggests that a rate cut this week is a viable option. He wrote, "While few think it's a possibility, maybe it should be considered."

Michael Green, Chief Strategist at Simplify Asset Management, said in a phone interview that an unexpected rate cut could unsettle investors. He agrees with Blinder's view that the first-quarter inflation spike may have been due to seasonal factors, and now seasonal factors favor lower inflation data.

Green said, "The question now is how far behind the curve the Fed is." After soaring inflation during the COVID-19 pandemic, the Fed embarked on the most aggressive rate-hiking cycle in history, raising the federal funds rate from near zero in March 2022 to the current 5.25%-5.5%.

At the same time, higher rates boosted the income of older and wealthier Americans, who were unwilling to reduce consumption with increased savings interest. But Green pointed out that this masked the actual pain in other parts of the economy, and Fed policymakers have been too slow to unwind their previous tightening policies.

As of now, the S&P 500 index has risen by about 14% year-to-date, with investors shifting from large tech stocks to small caps and other previously unpopular market sectors earlier this month, leading to a slight pullback in the index. The tech-heavy Nasdaq Composite Index has risen nearly 20% year-to-date, despite a 3.2% decline since July The small-cap Russell 2000 index rose more than 9% in July, with a year-to-date increase of 13.3%. The Dow Jones Industrial Average also rose 4% in July and 8% year-to-date.

The Federal Reserve may hint at a rate cut in September at Wednesday's meeting, which should be welcomed by investors. Green said, "The only situation that could cause a significant market decline is panic or severe uncertainty."

Not everyone believes that an unexpected rate cut on Wednesday will lead to a stock market decline.

Tom Essaye, founder of Sevens Report Research, said that although the likelihood of a rate cut on Wednesday is very low, if it happens unexpectedly, investors will respond positively, and the S&P 500 index could rise significantly by more than 1%, unless there is an extreme outflow of tech stocks.

Haworth believes that the greater risk is that investors may be disappointed with the expectation of a rate cut in September if the Fed emphasizes its reliance on future data. This situation could have a short-term negative impact on small-cap stocks and other cyclically sensitive stocks, some of which rebounded due to expectations of a rate cut in the fall