If the Federal Reserve unexpectedly cuts interest rates this week, the market may not be happy?

Investors are eager to get confirmation that the Federal Reserve will start cutting interest rates in September, but that doesn't mean the market will cheer if the Fed unexpectedly announces a rate cut early Thursday morning.

Rob Haworth, senior investment strategist at U.S. Bank, told MarketWatch on Tuesday: "The Fed catching the market off guard could cause some problems." He said the likely result would be a stock market decline, with U.S. Treasuries also being sold off as investors accelerate their expectations for future rate cuts.

Haworth said that while expectations of rate cuts have played a key role in the bull run of U.S. stocks, if there are no signals from policymakers before the Fed's blackout period, investors are likely to react negatively to a change in tone, viewing the move as "breaking with convention" and potentially raising concerns about larger issues in the economy or financial system.

Federal funds rate futures traders believe there is less than a 5% chance of a rate cut when the Fed concludes its two-day policy meeting early Thursday. In contrast, according to CME FedWatch Tool data, the probability of a rate cut of at least 25 basis points at the September meeting is 100%.

So why discuss the potential scenario of a rate cut this week? This is because an increasing number of economists, including some former Fed policymakers, believe that a rate cut may be coming too late.

Former New York Fed President William Dudley wrote in his widely followed Bloomberg column last week that soft economic data proved the July rate cut was justified, a stark departure from his previous call to keep rates higher for longer.

Former Fed Vice Chairman Alan Blinder pointed out in a guest column in The Wall Street Journal on Monday that while the market expects a rate cut in September, the current tightening of credit is "squeezing" the U.S. economy, though not suffocating it.

He noted that expectations lean towards a rate cut in September, but he believes a rate cut this week is a viable option. He wrote: "While few think it's a realistic possibility, maybe it should be...".

Michael Green, chief strategist at Simplify Asset Management, said in a phone interview that an unexpected rate cut this week is an "external possibility" but could make investors uneasy.

Green agreed with Blinder that seasonal factors could lead to a misleading rebound in first-quarter inflation. However, seasonal factors are now favorable for the Fed to receive more moderate inflation data.

Green said: "The question now is how far behind the curve the Fed is overall."

After inflation soared during the pandemic, the Fed aggressively caught up with the most aggressive rate hike cycle in history, raising the policy rate from near zero in March 2022 to the current 5.25%-5.5% At the same time, the increase in interest rates has also increased the income of elderly and wealthy Americans, who are reluctant to spend the income they have earned through higher savings rates. Greene said that this masks the true pain in other aspects of the economy, and Federal Reserve policymakers are now realizing that they have been too slow in unwinding past tightening policies.

Earlier this month, investors began a sharp rotation from large-cap tech stocks to small-cap stocks and other areas of the market that had previously been out of favor.

Subsequently, the S&P 500 index (SPX) retreated slightly from record levels, but still rose 14% year-to-date. The tech-heavy Nasdaq Composite Index (IXIC), after a 3.2% decline in July, is still up nearly 20% in 2024. The small-cap Russell 2000 Index (RUT) saw a gain of over 9% in July, bringing its year-to-date increase to 13.3%.

The Fed is likely to signal a rate cut in September on Thursday morning, which should be welcomed by investors. Greene said, "The only way to trigger a major sell-off in the market is through panic or severe uncertainty."

Not everyone believes that an unexpected rate cut by the Fed this week will lead to a stock market decline.

Brindley said he believes the market will "cheer."

Tom Essaye, founder of Sevens Report Research, said that while the likelihood of a rate cut this week is low, if it were to happen unexpectedly, investors would be very happy and the stock market is likely to rise significantly, with the S&P 500 index rising by over 1%, unless the rotation out of tech stocks proves to be extreme.

Haworth believes that the greater risk is that investors are hoping for the Fed to confirm a rate cut in September, but the Fed emphasizes that it still depends on the upcoming data, which could disappoint investors.

He said that if this leads investors to abandon their expectations for a rate cut in September, then at least in the short term, small-cap stocks and other cyclical sensitive stocks may face issues, as part of their rise has been due to increasing certainty of a rate cut