On September 18, the Federal Reserve cut official interest rates by 50 basis points. This is the most dovish surprise, outside of a crisis period, in 22 years. Initial reaction to the Fed’s rate cut suggests that this is potentially good news for financial markets, especially in the United States. However, State Street's array of market intelligence on risk, investor behavior, inflation and media sentiment may suggest otherwise.

'Significant macro uncertainties remain around the resting point of inflation, the steady state of short-term interest rates and the sustainability of fiscal policy. Any one of these factors could trigger a need to re-assess risk premia for all asset classes – something that investors may not be taking into account,' Michael Metcalfe says.

All of this points to the need for more careful diversification across assets and geographies in the coming years. In his latest article, Michael Metcalfe outlines what he has learned from the market reactions: 

• Lesson 1: The balance of risk has finally shifted, but uncertainty has not
• Lesson 2: Reaction to the Fed cut suggests interest rate markets got ahead of themselves, but a closer look at positioning suggests otherwise
• Lesson 3: Asset allocation trends remain stretched in favor of equities
• Lesson 4: Expect growing divergence across geographies and currencies

Michael Metcalfe also explains the long-term implications:

'September has demonstrated the 'Fed put' is firmly in place as the increasingly dovish tone of Chair Powell indicates. The market’s preliminary reaction is that this is good news for US equities, but it was still a modest disappointment for bond markets given elevated expectations for an easing cycle. We would, however, be wary of extrapolating these moves into 2025.

Long-term investor allocation to equities relative to bonds are already stretched in favor of equities. In lower inflation regimes, which we remain in for now, and during Fed easing cycles, which we have just begun, we note that allocations to bonds typically go up relative to equities, as they provide more reliable diversification benefits.

Given that growth and policy cycles are showing increasing signs of divergence, it also seems likely that country and currency risk will provide further diversification opportunities. This indicates that the current tendency to be significantly overweight US equities may be vulnerable,' Michael Metcalfe concludes.