Written by: Zhang Yaqi, Wall Street Watch

After a surge valued at $14 trillion, the booming U.S. stock market is approaching a critical turning point. The market anticipates 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 wave of trillions in funds triggered by passive investment, traditional market scripts may no longer apply.

Since the low in April, driven by expectations of multiple rate cuts by the Federal Reserve 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 an economic "hard landing," and investors are fiercely debating whether the Federal Reserve'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 Federal Reserve 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 Federal Reserve 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 markets will focus 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 Federal Reserve's official outlook aligns with this, it will undoubtedly boost stock market bulls.

History seems to be the "friend" of optimists. According to data from Ned Davis Research dating back to the 1970s, when the Federal Reserve pauses rate hikes for six months or longer before restarting cuts, the S&P 500 index averages a 15% increase in the following year, outperforming the average increase of 12% during the first cut of 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 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 rates. This is tricky."

Trillion-Dollar Fund Flows 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 challenges. David Solomon, CEO of Goldman Sachs, stated this week:

"When you look at the market's risk appetite, you don't feel that policy rates are very restrictive."

Market performance confirms his view. So far this year, ETFs have absorbed over $800 billion in funds, with $475 billion flowing into the stock market, on track to set a historical record of over $1 trillion in annual inflows. Even during the market pullback in April, data compiled by the media showed that ETFs still attracted $62 billion in 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, global macro strategist at StoneX Financial, described it:

"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 weak employment data or when the Fed hesitates. Market research has also found that when the Federal Reserve unexpectedly cuts rates, large-cap index funds often amplify gains; conversely, during unexpected rate hikes, they can cushion declines. The reason is mechanical: the process of ETF creation and redemption moves a basket of stocks all at once, thereby amplifying demand when funds flow in and mitigating shocks when they flow out.

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 fund flow may also be fragile. Nikolaos Panigirzoglou, a strategist at JPMorgan, pointed out that risk markets will not be troubled by a shift in rate cut expectations from 140 basis points to 120 basis points; "they will only truly feel concerned when the Federal Reserve signals that it will not cut rates at all."

Investment Script: Sector Rotation in the 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 Rob Anderson, a strategist at Ned Davis Research, historical rate-cutting cycles exhibit clear patterns. In periods of strong economic growth, where the Federal Reserve only makes one or two "preventive" cuts after a pause, cyclical sectors like financials and industrials perform best. Conversely, in periods of economic weakness requiring four or more significant cuts, investors favor defensive sectors, with healthcare and consumer staples showing the highest median returns.

Stuart Katz, Chief Investment Officer at wealth management firm Robertson Stephens, stated that the market depends on three major factors: the speed and magnitude of Federal Reserve rate cuts, whether AI trading can continue to drive growth, and whether tariff risks will trigger inflation. He believes that the unexpected decline in producer prices in August has alleviated inflation concerns, so he has been buying interest rate-sensitive small-cap stocks.

Other investors are focusing on different areas. Andrew Almeida, Director of Investments at XY Planning Network, is optimistic about mid-cap stocks, believing that although this category is often overlooked, it typically outperforms large-cap and small-cap stocks in the year following the start of rate cuts. He also favors financials and industrials 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 stated:

"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 us the answer."

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