The markets are currently navigating a complex landscape, marked by a palpable shift in expectations regarding Federal Reserve policy. Recent data painting a picture of slowing growth has prompted traders to anticipate more aggressive interest rate cuts in 2025, a sentiment that has taken hold for the first time this year.

This pivot is reflected in the increased probability of three rate cuts in 2025, and a growing debate over the timing of the next cut, with a roughly even chance now assigned to a May reduction. This contrasts sharply with the near-certainty of a rate hold just a week prior.

Ordinarily, the prospect of lower borrowing costs would be welcomed by both consumers and corporations, and by extension, the markets. However, the current market response has been decidedly negative. The S&P 500, a key barometer of market health, has dipped to levels not seen since before the presidential election.

Furthermore, traditional beneficiaries of anticipated rate cuts, such as the small-cap Russell 2000, have underperformed. The Russell 2000, typically responsive to expectations of monetary easing, has experienced a significant decline this year, far outpacing the relatively flat performance of the S&P 500.

This divergence underscores a crucial point: the rationale behind potential rate cuts matters. As Citi equity strategist Drew Pettit highlighted, if the Fed’s hand is forced by deteriorating economic conditions, the market’s reaction will likely differ from past instances of rate-cut optimism.

The recent economic data points to a potential slowdown. 

Consumer spending has contracted for the first time in nearly two years, and retail sales have witnessed their largest monthly decline in a year. The housing market remains sluggish, and recent manufacturing and construction spending figures have fallen short of expectations, leading to downward revisions of first-quarter growth forecasts.

Adding to the complexity are the projected economic impacts of new tariffs. These factors collectively contribute to a growing narrative that the Fed may be compelled to preemptively cut interest rates to avert an economic downturn, even if inflation remains above the central bank’s 2% target.

The market’s current unease stems from the recognition that rate cuts driven by economic weakness are fundamentally different from those aimed at stimulating a healthy economy. This distinction is critical as we navigate the shifting sands of Fed policy and assess the potential implications for our portfolios.