Fed rate cuts size: The market’s pivotal focus

By Raj Singh
Portfolio Manager, Multi-Asset

Markets are navigating a complex and often contradictory economic landscape. As Chair Powell noted during the 2025 Jackson Hole Economic Symposium, growth indicators remain resilient, but labor market data are beginning to show signs of strain, raising downside risks. While inflation isn't surging, the effects of tariffs are becoming visible, potentially leading to a more persistent inflation dynamic. Against this backdrop Chair Powell has nearly confirmed a Federal Reserve rate cut in September. However, the size of this cut poised to be pivotal.

The case for easing has strengthened, yet there's little economic justification for a large, emergency-sized cut of 50 basis points. Such a move might be interpreted by markets as being influenced by political pressures rather than driven by data, which could elevate inflation expectations and term premiums, pushing long-term yields higher and undermining the conditions that have supported risk assets. With valuations already stretched, the risk of a near-term market pullback could increase significantly. Markets may respond positively to a 25 basis point cut in September, but anything larger risks backfiring.

Despite this year's challenging policy environment, the S&P 500 has shown resilience. This year's equity rally has favored large-cap stocks, which significantly outperformed their smaller, less tech-heavy counterparts. While the prospects for the US large cap tech stock remain attractive on strong fundamentals, recently, however, small caps have begun to gain traction, buoyed by the increasing likelihood of Fed easing in September and support from the relatively attractive valuation. Historically, the reasons behind rate cuts matter: cuts made during deep recessions have negatively impacted on small-cap performance, while preemptive cuts in stable conditions have led to strong gains. Today's environment—characterized by subdued growth, contained inflation, and limited recession risk—resembles the latter, creating a more favorable setting for small-cap returns. However, lesser visibility of small cap earnings growth compared to large cap will remain a headwind.

In Asia, equities markets continued the rally in August with dovish Fed pivot providing further tail wind. China on-shore equities markets led the pack mainly driven by the strong liquidity on rotation from bonds to equities while policy makers took further incremental steps to support property market and consumption. The corporate earnings in China are mixed but households in China have significant excess savings which will keep supporting the market while Taiwan and Korea expected to keep benefiting from AI theme.

Fixed income continues to add value by providing downside mitigation and delivering real income. However, the complex macroeconomic landscape complicates yield forecasts for fixed-income investors, requiring a recalibration of risks and opportunities. U.S. Treasurys are benefiting from anticipated slower economic growth and hopes for future Fed easing. Periods of heightened volatility emphasize the diversification advantages of fixed income within a balanced portfolio. Given that uncertainty is likely to persist throughout the latter half of 2025, fixed income is well-positioned to deliver favorable outcomes across various asset classes. Investors should prioritize quality, exercise selectivity, and remain agile as policy developments unfold.