Author: Felix Jauvin, Blockworks; Translated by: Bai Shui, Golden Finance.
As early as September, the market predicted one of the most aggressive rate-cutting cycles I have seen, with multiple cuts of 50 basis points, quickly bringing the federal funds rate to 3% by 2025. Fast forward to today, the situation is completely different, with expectations of at most one or two cuts in 2025.
Let’s dive into the factors driving this change and the expected outcomes.
The chart below compares the Effective Federal Funds Rate (EFFR) with the two-year U.S. Treasury bond.
By comparing these two yields, we can draw some conclusions:
In the past two years, we have seen many times that the two-year interest rate has already reflected an upcoming aggressive rate-cutting cycle (for example, the two-year rate fell below the EFFR).
Since mid-2022, we have seen these two yields level for the first time. This means the market is digesting a rate-cutting cycle that is essentially already over, but it also does not see any possibility of rate hikes.
One major driver of the discussion around the rapid end of this brief rate-cutting cycle is unexpectedly stubborn inflation. As we saw in the December economic forecast summary, FOMC members have shifted from a balanced view on inflation to one where the risks are skewed to the upside.
Added to the fact that the current labor market has proven to be more resilient and robust than it was when the Federal Open Market Committee began rate cuts in September, these factors are making the possible outcome distribution more tilted towards a hawkish monetary response function.
Taking these factors into account, it becomes clear why there is an increasing belief that the rate-cutting cycle has ended.
That said, there are still dovish voices within the FOMC.
President 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 continuing to lower our policy interest rate in 2025. The pace of rate cuts will depend on the progress we make on inflation while preventing a weakening labor market.'
Like the past two years, 2025 will be another extreme year, with the market shifting from aggressive hawkish pricing to aggressive dovish pricing.
Investors need to quickly decide whether to try to navigate these shifts in sentiment or to view them as noise and ignore them.