Author: Felix Jauvin, Blockworks; Translated by: Baishui, Golden Finance

Back in September, the market was predicting one of the most aggressive rate cut cycles I have ever seen, with multiple 50 basis point cuts that would quickly take the Fed Funds rate to 3% by 2025. Fast forward to today, and the situation is completely different, with only one or two rate cuts expected in 2025 at most.

Let’s take a deeper look at what’s driving this change and what to expect.

Below is a chart comparing the effective federal funds rate (EFFR) to the two-year U.S. Treasury note.

By comparing these two yields, we can draw some conclusions:

  • Over the past two years, we have seen many times when the two-year rate already reflected an upcoming aggressive rate cut cycle (e.g., the two-year rate fell below the EFFR).

  • We are seeing these two yields move even for the first time since mid-2022. This means that the market is pricing in a rate cut cycle that is essentially over, but it also doesn’t see any chance of rate hikes.

One big driver of talk of a quick end to this short-lived rate-cutting cycle is surprisingly stubborn inflation. As we saw in the December Summary of Economic Projections, FOMC members have moved from inflation being roughly balanced to seeing risks as skewed to the upside.

Combined with the fact that the labor market is proving more resilient and robust now than it was in September when the FOMC began cutting rates, these factors are tilting the distribution of possible outcomes more toward a hawkish monetary reaction function.

Put these factors together and it's easy to see why there's growing confidence that the rate-cutting cycle is over.

That being said, there are still dovish voices within the FOMC.

Governor Waller mentioned in his speech this week that he still believes there will be rate cuts this year: "So what is my view? If the outlook develops as I have described here, I would support continued reductions in our policy rate through 2025. The pace of these reductions will depend on the progress we make on inflation while preventing a weakening in the labor market."

Like the past two years, 2025 will be another year of extremes, with the market moving from aggressive hawkish pricing to aggressive dovish pricing.

Investors need to decide quickly whether to try to ride these sentiment changes or ignore them as noise.