Federal Reserve Policy and Its Impact on Equity Markets: Positioning for a 99% Rate Cut Probability in Q4 2025

The Federal Reserve’s policy trajectory in late 2025 has become a focal point for investors, with markets pricing in a near-certainty of rate cuts. According to the CME FedWatch Tool, the probability of a 25-basis-point reduction at the September 2025 meeting stands at 99.6%, driven by a weak August jobs report and persistent inflation moderation [1]. This high probability reflects a stark shift from the Fed’s July 2025 stance, where officials left rates unchanged at 4.25–4.5% amid caution over inflationary risks from tariffs and a resilient economy [2].

The Fed’s Dovish Turn: A Delicate Balance

The Federal Open Market Committee (FOMC) has signaled a gradual easing path, projecting a federal funds rate of 3.9% by year-end 2025, with further reductions expected into 2026 [3]. Governor Christopher Waller, a known dove, has explicitly advocated for a 25-basis-point cut in September and two additional cuts by year-end, aligning with J.P. Morgan Research’s forecast of a target rate of 3.25–3.5% by early 2026 [4]. However, the Fed’s July meeting minutes revealed internal divisions, with two dissenters favoring immediate action. Chair Jerome Powell emphasized the need for “data-dependent” decisions, underscoring concerns about inflation remaining above 2% through 2026 due to tariff-driven import price pressures [5].

Economic Fundamentals: Cooling Labor Markets and Mixed Inflation Signals

The August jobs report, which added just 22,000 nonfarm payrolls—far below expectations—has intensified calls for rate cuts. The unemployment rate rose to 4.3%, the highest since 2017, while average hourly earnings growth slowed to 3.7% year-over-year, the weakest since July 2024 [6]. Meanwhile, inflation data remains a mixed bag: the annual CPI-U in July 2025 held at 2.7%, but core inflation accelerated to 3.1%, driven by shelter costs [7]. The Federal Reserve Bank of Cleveland’s nowcast estimates 0.3% year-over-year inflation for August, suggesting further moderation is unlikely in the near term [8].

Equity Market Implications: Sectors to Watch and Risks Ahead

A 99% probability of rate cuts in Q4 2025 has already spurred investor positioning in rate-sensitive sectors. Historically, rate cuts have buoyed growth stocks, particularly in technology and real estate, as lower borrowing costs reduce discount rates for future cash flows. For instance, the S&P 500’s tech-heavy Nasdaq has outperformed in 2025, with investors anticipating a dovish Fed. However, risks persist: the Congressional Budget Office (CBO) projects a slower path of easing than markets expect, forecasting a federal funds rate of 3.7% by Q4 2025 [9]. If the Fed delays cuts due to stubborn inflation or stronger-than-expected data, equities could face volatility, particularly in sectors like utilities and consumer discretionary, which have benefited from the rate-cut narrative.

Strategic Positioning for Investors

Investors should adopt a dual approach:
1. Sector Rotation: Overweight sectors historically sensitive to rate cuts (e.g., technology, real estate) while underweighting sectors vulnerable to inflation (e.g., energy, materials).
2. Hedging Against Policy Divergence: Use options or Treasury futures to hedge against the risk of a slower-than-anticipated easing cycle, particularly if inflation resists the downward trend.

The Fed’s September meeting will be pivotal. While the 99.6% cut probability suggests a near-certain move, the broader economic context—tariff uncertainty, a cooling labor market, and mixed inflation data—demands vigilance. As former Fed officials have warned, acting on market sentiment alone could undermine long-term credibility [10]. For now, investors must balance optimism about rate cuts with caution about the Fed’s data-dependent approach.

Source:
[1] CME FedWatch Tool, August 2025 [https://www.cmegroup.com/trading/interest-rates/interest-rate-futures.html]
[2] Federal Reserve, July 2025 Meeting Minutes [https://www.federalreserve.gov/monetarypolicy/fomcprojtabl20250618.htm]
[3] J.P. Morgan Research, "What's The Fed's Next Move?" [https://www.jpmorgan.com/insights/global-research/economy/fed-rate-cuts]
[4] Speech by Governor Waller, August 28, 2025 [https://www.federalreserve.gov/newsevents/speech/waller20250828a.htm]
[5] Schwab Report, "Fed Interest Rates: FOMC Holds Steady" [https://www.schwab.com/learn/story/fomc-meeting]
[6] Bureau of Labor Statistics, August 2025 Employment Report [https://www.bls.gov/news.release/empsit.nr0.htm]
[7] Bureau of Labor Statistics, July 2025 CPI Summary [https://www.bls.gov/news.release/cpi.nr0.htm]
[8] Federal Reserve Bank of Cleveland, Inflation Nowcasting [https://www.clevelandfed.org/indicators-and-data/inflation-nowcasting]
[9] Congressional Budget Office, "The Budget and Economic Outlook: 2025 to 2035" [https://www.cbo.gov/publication/61172]
[10] Reuters, "September Fed Rate Cut Odds Fall Ahead of Jerome Powell’s Jackson Hole Speech" [https://www.mexc.com/et-EE/news/september-fed-rate-cut-odds-fall-ahead-of-jerome-powells-jackson-hole-speech/69309]