Fed Policy & Market Whipsaw

Despite the fact that many leading economic indicators in recent years have been warning that a recession was just on the horizon, 2024 was a year of many positive economic and financial surprises, such as the AI boom (reflected in the stock performance of many megacap tech stocks), massive risk-taking appetites in stock and bond markets (reflected by rich valuations and tight credit spreads), and a resilient labor market and economy more generally.

By last September, with inflation appearing to be increasingly contained and unemployment rising in a seemingly slow and controlled manner, the Federal Reserve terminated its 2022-2024 rate-hiking cycle and began what was expected to be a prolonged cycle of rate cuts. This policy pivot only added to the sunny risk-taking outlook. But in a year of surprises, it’s fitting that 2024 closed with another big one, as the Fed pivot got stopped in its tracks.

Following the FOMC’s last three meetings (September, November and December), the Fed reduced the target funds rate by 100 basis points, to 4.25%-4.5% from 5.25%-5.5%. In September, when dovish expectations were at their highest, fed funds futures were expecting the funds rate would fall to 2.75% by year-end 2025. Today, the market expects only another 25 basis points in cuts. However, some banks and analysts such as Bank of America now assume no rate cuts this year.

So what changed? Perhaps the most important change has been the market’s expectations of inflation. In September, the 5-year TIPS spread was implying nearly a 1.9% annual inflation rate during the next 5 years. Today, the spread suggests an annual rate of 2.5%, which meaningfully exceeds the Fed’s long-term 2% inflation target. At the same time, labor market loosening seems to have stalled, with the unemployment rate falling to 4.13% in December from 4.17% in September.

With this change of dynamics within the Fed’s dual mandate, toward one of higher inflation amid a solid employment environment, the Fed is likely to be on an “extended hold” where forthcoming inflation and jobs data will determine the path of rate policy in 2025.

The significant change in the Fed outlook has clearly impacted financial markets, with the S&P 500 down more than 5% from its highs. But arguably the most impacted market segment has been in Treasuries, where for example the 10-year Treasury yield has sky-rocketed from 3.65% in mid-September to more than 4.75%. As we saw during the beginnings of rate-cutting cycles in 2001 and 2007, a little increase in long-term yields typically occurs after the first rate cut – somewhere between 20-40 basis points. But the recent 100+ basis point increase in the 10-year yield is highly unusual and is consistent with the quick change in the Fed policy outlook.

We believe that the change in inflation expectations and shift in the Fed policy outlook has a lot to do with the presidential election and the anticipation that President Trump’s new economic policies, notably tax cuts and deregulation, which could spur economic growth and in so doing boost statistical inflation statistics.

We wouldn’t be surprised if the President-elect and the Fed will again be in conflict over interest rate policy, as they were in 2017-2018. Incidentally, President Trump was arguably proven right then. In our view, the equity markets’ December 2018 selloff occurred largely in reaction to hawkish Fed comments at the time, and the tantrum compelled policymakers to quickly pivot to rate cuts in 2019.

For now, all eyes will be on the daily streams of economic data and the specific policy proposals out of Washington to forecast the path of inflation, employment and interest rates. We’ll likely see an unusually fast, perhaps unprecedented pace of policy changes in the coming months regarding taxes, deregulation, tariffs, immigration, and geopolitics. The influx will likely lead to much more economic and financial volatility.