by Kevin Flanagan, Head of Fixed Income Strategy, WisdomTree
Key Takeaways
- Following November's quarter-point rate cut, the narrative around the Fed's rate cut outlook has shifted, with future policy decisions remaining highly data dependent.
- A resilient economy and labor market that is not as “cold” as envisioned have tempered rate-cut expectations, pushing bond yields higher in the process.
- Investors should monitor Fed signals on both rate cuts and quantitative tightening, as a possible pause in rate cuts could shape bond and equity markets in early 2025.
Following the September FOMC meeting’s much ballyhooed 50-basis point (bps) rate cut, the voting members scaled back and reduced the Fed Funds by 25 bps this time around. This brings the new Fed Funds trading range down to 4.50%–4.75%. Regarding the future course of monetary policy, as I’ve been emphasizing for a while now, the money and bond markets will be continuing to adjust their pricing mechanism toward what this rate cutting cycle will ultimately look like. And, in a data-dependent monetary policy world, that will leave plenty of room for further speculation for not only the December Fed meeting, but perhaps more importantly, for 2025, as well.
One important aspect that comes to mind is the notable difference in the narrative that accompanied the November FOMC gathering as compared to back in September. Let’s go back six weeks or so and remember what assumptions the Fed, and by extension, the money and bond markets, were operating under. The economy/labor markets appeared to be cooling more than previously expected, progress on inflation was continuing, and this would likely result in an aggressive Fed rate cutting cycle. Indeed, at one point, the implied probability for Fed Fund Futures was looking at a 2.80% target by Q4 2025 and Treasury yields had plunged by 100 bps.
Let’s fast forward to the present. The inter-meeting data has revealed an economy showing continued resilience, the pre-hurricane/strike-related labor market is showing signs of not being as cool as originally thought, and inflation numbers hit a roadblock. Needless to say, these developments completely changed Fed rate cut expectations. Fed Funds are now being discounted to 3.60% by Q4 of next year and U.S. Treasury coupon yields are all back over the 4% threshold, as of this writing.
Where do Powell & Co. go from here? Obviously, monetary policy remains highly data dependent. Another quarter-point reduction in the Fed Funds Rate seems a likely scenario for the December FOMC meeting, data permitting. But this is where things could get very interesting. If the economic/labor market data continue to show signs of not cooling too much, and inflation gets sticky around current levels, a reasonable case scenario could involve the Fed taking a pause to reassess things to begin 2025. That doesn’t necessarily mean the rate cut cycle would end. However, the policy makers would have already cut rates by 100 bps in this backdrop, so perhaps Powell & Co. taking stock could make sense.
Is there anything else investors should be on the lookout for from the Fed? How about their future plans for quantitative tightening (QT)? The policy makers have already tapered their pace of balance sheet reduction, so it wouldn’t be out of the question at all if the next step in the months ahead would be to end QT at some point in 2025.
The Bottom Line
As we have seen so many times over the last few years, monetary policy will remain a fluid process, and this rate cut cycle will more than likely be no different.
