U.S. equity markets closed out Friday with the highest weekly return of 2024 following the worst loss on the year in the week prior. The rebound was supported by a recovery in AI enthusiasm that boosted tech stocks as well as the release of inflation data that reinforced expectations for the Federal Reserve to start cutting interest rates at this week’s meeting. The S&P 500 snapped back from a 4.2% loss in the week prior with a 4.1% gain last week, bolstered by a 7.3% gain for the information technology sector. Meanwhile, the tech-laden Nasdaq Composite jumped 6.0% and the Dow Jones advanced 2.6%. Small cap stocks participated in the rally as well on rate cut enthusiasm with the Russell 2000 returning 4.4%.

This week’s Federal Reserve meeting is among the most anticipated economic events this year by investors as it will officially begin the central bank’s pivot toward easing monetary policy from restrictive levels. Currently, market participants are split between expectations for an initial cut of 0.50% or 0.25%. According to the CME FedWatch tool, markets are pricing in 61% odds of the former and 39% odds for the more modest alternative. Last week’s slightly hotter than expected CPI inflation reading seemed to bolster the case for easing into rate cuts with a 0.25% reduction this week. Core CPI growth ticked up in August (up 0.3% over July, which was a tenth higher than consensus) as core services, particularly, shelter prices, surprised to the upside after several months of encouraging news. However, the year-over-year readings continued to move in the right direction as headline CPI ticked down to 2.5% year-over-year from 2.9% in July and core CPI (excluding food and energy) held steady at 3.2%.

Proponents of a 0.25% rate cut at this week’s meeting generally point to still solid economic growth and sticky service inflation readings as rationale for a more gradual trajectory to rate cuts. They argue that a more aggressive initial rate cut could either spook the market as it would indicate that the Fed is concerned about deterioration in the labor market or prove premature as inflation remains above the 2% target and swift easing could reignite inflationary forces. On the other hand, advocates for a half percentage point cut generally are concerned that current policy is much too restrictive. They believe it would be better to err on the side of easing too quickly as opposed to remaining too restrictive for too long and risking a rising trend in layoffs that historically has been very difficult to arrest once started.

While the labor market is certainly softening as evidenced by slowing job gains and falling job openings, evidence of any material rise in layoffs remains muted. Weekly unemployment insurance claims have trended downward since peaking in July amid summer auto plant shutdowns and temporary layoffs associated with Hurricane Beryl. The 4-week moving average of initial jobless claims was 231k as of last week, which is down from 241k in July and low compared to long-term historical averages.

Although this week will kick off the official start of the easing cycle, it’s important to note that the market has already done a lot of the groundwork of baking in expected rate cuts as the Fed has telegraphed this path. For example, the 2-year U.S. Treasury yield has fallen to around 3.56% today, which is nearly a 1.50% drop from the highs over 5% at the end of April. The Federal Reserve’s Dot Plot, which will be updated at this week’s meeting, will give important insight to the central bank’s longer-term expectations for rate cuts beyond this meeting. Market participants currently expect cumulative rate cuts totaling around 2.50% by the end of 2025, thereby taking down the Fed’s short-term policy rate from 5.33% today to below 3.0%, but these expectations will fluctuate based on the Fed’s commentary alongside any incremental news on the labor market or inflation.

The approaching presidential election also continues to garner investor attention and a high amount of uncertainty. Most polling suggests that the presidential race is a toss-up following last week’s debate between VP Kamala Harris and former president Donald Trump. Polling trends at the congressional level are also mixed with Democrats appearing better positioned in the House and Republicans favored in the Senate, according to Oxford Economics. A split government is generally viewed as a favorable outcome for markets as it reduces the likelihood of large swings in policy that could contribute to market volatility.