To The Moon

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Current Situation

The Federal Reserve recently lowered rates slightly but indicated that future rate cuts may not occur as previously expected. The updated "dot plot" now shows a slower pace of rate reductions. For example, projections for 2026, which once anticipated rates below 3%, now place them at 3.5%. Similarly, rates for 2025, expected to reach 3%, are now projected to stay at 4%.

This reflects a shift in expectations. The Fed has acknowledged that inflation is not returning to the 2% target as quickly as anticipated. The median projection for inflation at the end of next year has risen from 2.1% to 2.5%, suggesting that rates will remain higher for longer.

Recent economic data indicating a resilient labor market and persistent inflation have led the Federal Reserve to adopt a more cautious approach to interest rate cuts in 2025. In December 2024, the Fed reduced the federal funds rate by 25 basis points to a target range of 4.25% to 4.5%, marking a total reduction of 100 basis points since September. However, officials now project only two additional quarter-percentage-point cuts by the end of 2025, bringing the rate down to a range of 3.75% to 4.0%.

The Federal Reserve cut interest rates on 18Dec24 as anticipated, but Chair Jerome Powell emphasized that further reductions would depend on continued progress in reducing persistently high inflation. Powell's remarks signaled that policymakers are beginning to grapple with potential sweeping economic changes under the Trump administration, prompting a strong market reaction.

His cautionary tone unsettled Wall Street, leading to a sharp decline in stock prices, a rise in bond yields, and scaled-back expectations for additional rate cuts over the next year. "I think we're in a good place, but I think from here it's a new phase, and we're going to be cautious about further cuts," Powell stated during a press conference following the Federal Open Market Committee's decision to lower the benchmark interest rate by 0.25 percentage points at the conclusion of its two-day meeting.

Powell highlighted the progress made in reducing inflation since its 2022 peak while acknowledging recent stagnation, particularly in shelter costs, which have been slower to decline than anticipated. Although the Fed remains optimistic that inflation will continue to ease, Powell noted that central bank staff and policymakers have begun preliminary discussions on how President-elect Donald Trump’s proposed policies—such as higher tariffs, tax cuts, and stricter immigration measures—could impact the economic outlook.

Some policymakers have started to incorporate tentative estimates of these policy effects into their forecasts. According to Powell, new projections indicate a higher inflation outlook and fewer rate cuts in the coming year. An index measuring the risk associated with inflation forecasts has also risen sharply, reflecting heightened uncertainty compared to projections issued before the November election.

The Fed's updated projections suggest that core inflation, as measured by the personal consumption expenditures (PCE) price index excluding food and energy, is likely to remain at 2.5% through 2025—an improvement from this year’s 2.8% but still above the Fed’s 2% target. "Uncertainty and upside risks to core PCE inflation have risen significantly since September, largely due to potential impacts from new government policies," observed Karim Basta, chief economist at III Capital Management.

Market Reaction

Despite the recent rate cut, bond yields have increased, with the 10-year Treasury yield climbing from 3.5% in September to 4.5%. This reflects market skepticism about shorter-term rate movements, tied closely to inflation expectations. On the day of the announcement, the stock market dropped by 3%, the VIX spiked, and even Treasuries saw declines.

Emerging markets and the S&P 500 both fell, highlighting the market's sensitivity to higher rates. These reactions underscore the complexity of the current economic environment.

TLT

This tempered outlook is influenced by stronger-than-expected economic indicators. For instance, U.S. job openings unexpectedly rose to 8.1 million in November, suggesting continued labor market resilience.Additionally, an acceleration in the services sector activity has contributed to uncertainty regarding the Fed's easing cycle.

The anticipation of a slower pace of rate cuts has impacted financial markets, notably causing an increase in U.S. Treasury yields. The 10-year Treasury note yield reached 4.68%, its highest since May, exerting pressure on rate-sensitive sectors such as technology.

A line chart titled "US federal funds target rate" that tracks the metric over time. The interest rate was lowered 0.25 percentage points in December.

U.S. central bankers now anticipate implementing only two quarter-percentage-point rate cuts by the end of 2025. This represents half a percentage point less policy easing than projected in September. The revision reflects higher inflation expectations for the first year of the Trump administration, with forecasts rising from 2.1% to 2.5%.

The slower pace of inflation reduction, which is not expected to reach the Fed's 2% target until 2027, has led to a more gradual rate-cut trajectory and a slightly higher terminal rate of 3.1% by 2027, compared to the 2.9% endpoint projected in September.

A scatter chart titled "The Fed’s dot plot." Interest rate projections by officials at the Federal Open Market Committee

Inflation and Global Factors

Central banks, including the Fed, may be underestimating the global nature of inflation. Factors such as energy, commodities, and wages, especially in emerging markets, play a significant role. For example, wages in China have more than doubled in the last decade, while in Europe, they’ve seen slower growth.

The demand for resources from emerging markets, home to over 4.3 billion people, is reshaping global supply and demand dynamics. This trend, driven by a younger and growing population, could have long-term implications for inflation and economic policies.

Will the Fed Burst the Stock Market Bubble?

The Fed’s revised rate forecasts have significant implications for asset values. For instance, the S&P 500’s current earnings yield is around 3.33%, corresponding to a price-to-earnings ratio of 30. If rates rise to 4%, this could push the P/E ratio to 25 or lower, implying a potential market correction to around 4,000 points. A more significant correction, perhaps to 3,000 points, is possible if earnings expectations are adjusted downward or if economic conditions worsen.

Risk and Reward

Predicting market crashes or precise economic outcomes is nearly impossible. History suggests that bubbles do eventually burst, but timing and severity remain uncertain. As investors, our focus should be on building portfolios brick by brick, assessing risk and reward, and ensuring that we are prepared for various scenarios.

TRUMP UNCERTAINTY

The policy rate is now a full percentage point lower than its peak in September, when officials believed inflation was on track to return to the 2% target and viewed prolonged tight monetary policy as a potential risk to the labor market.

Since then, key inflation measures have shown little change, while persistently low unemployment and stronger-than-expected economic growth have sparked debates among policymakers about whether monetary policy is as restrictive as previously thought.

Although Donald Trump does not assume office until January 20, Federal Reserve Chair Jerome Powell noted that Fed staff have been modeling various scenarios for what could be an unpredictable year.

Conclusion

While markets may behave irrationally for extended periods, staying disciplined and adaptable will help us navigate the challenges ahead.

Investors are advised to monitor upcoming economic reports, including non-farm payrolls and the Fed's meeting minutes, for further insights into the central bank's policy direction. The Fed's cautious stance reflects its commitment to balancing economic growth with inflation control, suggesting that significant rate reductions in 2025 are unlikely unless there is substantial progress in lowering inflation.

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