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Investors are eager for the Federal Reserve to start cutting interest rates in September, but markets would not necessarily be pleased if the central bank announced a surprise rate cut on Wednesday.

Zhitong Finance APP learned that Rob Haworth, senior investment strategist at Bank of America, said in an interview: "If the Fed takes action when the market does not expect it, it may cause some problems." He pointed out that this may lead to a decline in the stock market and a sell-off of U.S. bonds as investors will accelerate their expectations of future interest rate cuts.

While expectations of rate cuts have played a major role in the bull run in U.S. stocks, Haworth noted that if rate cuts are not foreshadowed by policymakers, investors may interpret it as a "breach of convention" and worry about larger problems in the economy or financial system.

Fed funds futures traders see less than a 5% chance the Fed will cut rates at the end of its two-day policy meeting on Wednesday, according to the CME FedWatch tool. Instead, the market has fully priced in at least a 25 basis point cut at the Fed’s September meeting.

So why is there talk of a rate cut on Wednesday? Some economists, including some former Fed officials, think a rate cut is long overdue. Former New York Fed President William Dudley said in his widely read column that weak economic data justified a July rate cut, a shift from his previous stance of maintaining higher interest rates.

Alan Blinder, former vice chairman of the Federal Reserve, pointed out in an article that the market generally expects a rate cut in September, but funds are currently tight and the Federal Reserve is "squeezing" the US economy. He believes that a rate cut in September is more likely, but also proposed that a rate cut this week is a viable option. He wrote: "Although few people think this is a possibility, perhaps it should be considered."

Michael Green, chief strategist at Simplify Asset Management, said in a phone interview that an unexpected rate cut could unsettle investors. He agreed with Blinder that the first-quarter inflation increase was likely artificial due to seasonal factors that now favor lower inflation data.

“The question now is how far behind the Fed is overall,” Green said. After inflation surged during the COVID-19 pandemic, the Fed embarked on the most aggressive rate-hike cycle in history, raising the federal funds rate from near zero in March 2022 to the current range of 5.25%-5.5%.

At the same time, higher rates boosted the incomes of older, wealthier Americans, who were reluctant to cut back on spending as their savings grew in interest. But that masked real pain in the rest of the economy, Green said, and Fed policymakers were too slow to undo earlier tightening policies.

The S&P 500 is up about 14% for the year so far, after a pullback earlier this month as investors rotated out of big tech stocks and into small-cap stocks and other previously unloved market sectors. The tech-heavy Nasdaq Composite is up nearly 20% year to date, though it has retreated 3.2% since July.

The Russell 2000 index of small-cap stocks rose more than 9% in July, bringing its year-to-date gain to 13.3%. The Dow Jones Industrial Average also rose 4% in July and is up 8% for the year.

The Fed is likely to hint at a September rate cut at its meeting on Wednesday, which should be welcomed by investors. “The only scenario that could cause a significant market decline is if there is panic or severe uncertainty,” Green said.

Not everyone thinks Wednesday's surprise rate cut will cause stocks to fall.

Tom Essaye, founder of Sevens Report Research, said that while a rate cut on Wednesday is highly unlikely, if there is an unexpected rate cut, investors will respond positively and the S&P 500 could surge more than 1% unless the rotation out of tech stocks is very extreme.

Haworth believes that the greater risk is that investors may be disappointed with the expectations of a rate cut in September if the Fed emphasizes that it still depends on future data. This situation may have a short-term negative impact on small-cap stocks and other cyclically sensitive stocks, which have rebounded in part on the expectation of certainty of a rate cut in the fall.