What will happen next week when the U.S. stock market, which has surged 32% in 5 months, meets the Federal Reserve that is resuming interest rate cuts?

After experiencing a surge valued at $14 trillion, the booming U.S. stock market is facing a critical turning point. The market expects that the Federal Reserve will restart its rate-cutting cycle next week; however, when a bull market driven by expectations of central bank easing encounters a deeper, trillion-dollar wave of funds triggered by passive investment, traditional market scripts may no longer apply.

Since the low in April, driven by expectations that the Federal Reserve will cut rates multiple times this year, the S&P 500 index has soared 32%, with the market almost fully pricing in a 25 basis point rate cut next Wednesday. Historical data seems to favor the bulls, but recent economic data, including employment reports, has raised warning signals, triggering concerns about the risk of a "hard landing" for the economy, and investors are fiercely debating whether the Fed's actions are too late.

The core of this debate about the market's direction lies in the speed of economic slowdown and how aggressively the Federal Reserve needs to ease policy in response. Traders' bets not only affect asset prices but also determine investment strategy choices from tech giants to small companies.

Meanwhile, a profound structural shift may be undermining the traditional influence of the Federal Reserve's monetary policy. A trillion-dollar wave of funds led by exchange-traded funds (ETFs) is continuously flooding into the market in an "autopilot" mode, providing stable support for risk assets regardless of whether economic data is good or bad. This phenomenon complicates next week's Fed decision: is the market cheering for policy easing, or is it operating under its own strong fund flow logic?

The Economic and Market Game Under Rate Cut Expectations

At 2 PM next Wednesday, global market attention will be focused on the Federal Reserve's post-meeting statement, the latest interest rate forecast "dot plot," and Chairman Powell's speech half an hour later. Data shows that interest rate swap contracts have fully priced in at least one 25 basis point rate cut and expect about 150 basis points of cumulative cuts over the next year. If the Fed's official outlook aligns with this, it will undoubtedly boost the stock market bulls.

History seems to be the optimists' "friend." According to data from Ned Davis Research dating back to the 1970s, after the Federal Reserve pauses rate hikes for six months or longer and then restarts rate cuts, the S&P 500 index averages a 15% increase in the following year, outperforming the average increase of 12% during the same period after the first cut in a typical rate-cutting cycle.

However, concerns are also very real. Although economic growth is currently relatively strong and corporate profits remain healthy, some ominous signs have emerged, with a report showing the unemployment rate rising to its highest level since 2021 intensifying people's doubts. Sevasti Balafas, CEO of GoalVest Advisory, stated:

"We are at a unique moment, and the biggest unknown for investors is the extent of the economic slowdown and how much the Federal Reserve needs to cut interest rates. This is tricky."

Trillions of Dollars Flow Reshaping Market Logic

Traditionally, the Federal Reserve's benchmark interest rate has been the "conductor" of Wall Street's risk appetite. However, this logic is now facing severe tests. Goldman Sachs CEO David Solomon stated this week:

"When you look at the market's risk appetite, you don't feel that the policy rate has very strong restrictive effects."

The market's performance confirms his viewpoint. So far this year, ETFs have absorbed over $800 billion in funds, with $475 billion flowing into the stock market, likely setting a historical record for annual inflows exceeding $1 trillion. Even during the market pullback in April, according to data compiled by the media, ETFs still attracted $62 billion in fund inflows. Behind this is a structural force known as the "autopilot effect": trillions of dollars in retirement savings are regularly and automatically invested into passive index funds through 401(k) plans, target-date funds, and model portfolios.

Vincent Deluard, a global macro strategist at StoneX Financial, described it as:

"We have invented a perpetual motion machine; regardless of valuations, market sentiment, or macro environment, we are putting about 1% of GDP into index funds every month."

This "inelastic demand" explains why fund inflows remain robust even during periods of weak employment data or the Fed's indecision. Market research has also found that when the Fed unexpectedly cuts rates, large-cap index funds tend to amplify gains; conversely, during unexpected rate hikes, they can cushion declines. The reason is mechanistic: the subscription and redemption process of ETFs moves a basket of stocks all at once, thereby amplifying demand during inflows and mitigating shocks during outflows.

The conclusion of this finding is that ETFs have become so central to market infrastructure that they can influence how monetary policy transmits through the market.

However, this seemingly permanent flow of funds may also be fragile. JPMorgan strategist Nikolaos Panigirzoglou pointed out that risk markets will not be troubled by a shift in rate cut expectations from 140 basis points to 120 basis points, "only when the Fed sends a signal that it will fundamentally not cut rates will they truly feel concerned."

Investment Script: Sector Rotation in a Rate-Cutting Cycle

In anticipation of the upcoming rate cuts, investors are actively deploying their "trading scripts," and historical experience provides strategic references for different scenarios.

According to data compiled by Ned Davis Research strategist Rob Anderson, historical rate-cutting cycles exhibit clear patterns. In periods of strong economic performance, where the Fed only makes one or two "preventive" rate cuts after a pause, cyclical sectors such as financials and industrials perform best. Conversely, in periods of economic weakness requiring four or more significant rate cuts, investors prefer defensive sectors, with healthcare and consumer staples showing the highest median returnsStuart Katz, Chief Investment Officer of wealth management firm Robertson Stephens, stated that the market depends on three major factors: the speed and magnitude of the Federal Reserve's interest rate cuts, whether artificial intelligence trading can continue to drive growth, and whether tariff risks could trigger inflation. He believes that the unexpected decline in producer prices in August has alleviated inflation concerns, which is why he has been buying small-cap stocks that are sensitive to interest rates.

Other investors are focusing on different areas. Andrew Almeida, Director of Investments at XY Planning Network, is optimistic about mid-cap stocks, stating that although this category is often overlooked, it typically outperforms large-cap and small-cap stocks in the year following the start of interest rate cuts. He also favors the financial and industrial sectors that can benefit from lower borrowing costs.

Meanwhile, some investors choose to stick with this year's leading stocks. Sevasti Balafas of GoalVest Advisory continues to hold shares of Nvidia, Amazon, and Alphabet, betting that a gradual economic slowdown will not disrupt the earnings growth of these giants.

As Katz said:

"If growth slows, the Federal Reserve will cut rates, but if the economy stalls too quickly, the risk of recession will rise. So, how tolerant are investors of an economic slowdown? Time will tell."

Risk Warning and Disclaimer

The market carries risks, and investment should be approached with caution. This article does not constitute personal investment advice and does not take into account the specific investment goals, financial situation, or needs of individual users. Users should consider whether any opinions, views, or conclusions in this article align with their specific circumstances. Investment based on this is at one's own risk