The US Federal Reserve is marking the beginning of a new phase of rate cutting cycle after 4 years in global markets and is all set to cut rates from the current 23-year high of between 5.25 and 5.50%. As for the stock market reaction, it all depends on whether Jerome Powell opts for a 25bps or 50bps cut and why.

About two-thirds of Wall Street traders are pricing in the possibility of a 50 basis point rate cut on Wednesday and a total rate cut of 100 basis points by the end of December 2024. But the market has a history of errors when it comes to predicting the vote of the rate-setting panel Federal Open Market Committee (FOMC).

If Powell cuts rates by 25bps but says he won’t let ugly inflation rise again, that could be positive for the market. But if the Fed cuts drastically by 50bps and says they need to do more and are worried about growth, that could stress stock prices because investors could see it as a signal that the US economy is going into recession.

On the one hand, the Fed needs to lower interest rates to support the economy, but on the other hand, they don’t want inflation to rise again.

Also read | US Fed meeting begins. Does the stock market need a 25 or 50 bps rate cut?

“They will sell two different things to two different voters. To the fixed income guys, they will say inflation is coming down and that’s why I am cutting rates. And to the equity market, they don’t want to say I am cutting rates because the economy is slowing down,” Nilesh Shah, MD, Kotak Mahindra Mutual Fund, told ETMarkets.

When asked to comment on the magnitude of the Fed’s rate cuts, he said the actual rate will be much lower than what the market is predicting.

An ideal and possible outcome, analysts say, would be a 25 basis point rate cut with a dove-like message, indicating a series of rate cuts.

As the rate cut cycle begins, S Naren, top stock selector at Dalal Street and ICICI Prudential Mutual Fund, said the ideal strategy is to focus on asset allocation.

“A rate cut is typically a sign of a slowing economy, which means that equity earnings may not grow significantly. That’s why it’s crucial to avoid leverage and limit excess risk in your portfolio. Instead, focus on investing in quality stocks: quality-oriented value rather than aggressive value stocks,” he said.

Furthermore, he said that one should avoid leverage – or, if one has bought leveraged stocks, reduce them to zero and book a profit.

A Capitalmind study shows that the Fed has announced 10 rate cuts of 50 basis points over the past 30 years, resulting in an average return of 1.6% for the Nifty.

“A 25 bps cut was followed by a more modest median Nifty return of -0.5%. There are outliers too, such as the nearly 7% drop in October 2008 after a 50 bps cut in the midst of the global meltdown during the global financial crisis,” Capitalmind said.

Lower rates could also lead to higher inflows from foreign investors. Ahead of the rate cut cycle, FIIs have already invested Rs 31,000 crore in Dalal Street so far this month.

Investors believe that rate cuts would be positive for banks and NBFCs.

“Rate cuts can lead to a lot of treasury gains on the investment book of banks. They are the cheapest sector (relatively historically) in the entire market right now. So I believe rate cuts would be a positive for banks and NBFCs. It can also help them with their borrowing costs. That’s how we see it right now,” Naren said.

Meanwhile, Wall Street expects the RBI to cut rates by at least 25 basis points before December.

“Why should the RBI be in a hurry? India is the fastest growing major economy. Inflation is coming down and will be below 4% but overall inflation will be between 4% and 6%, which is the upper end of the RBI target range. The rupee is stable. Foreign inflows are happening in the debt market. There is no need for the RBI to follow the Fed immediately. They have all the time in the world to hit the ball when they decide to hit it,” said Kotak’s Nilesh Shah.

Also Read | As the Stock Market Shifts from Value to Quality, How S Naren Invests