Expected 25 Basis Point Rate Cut: The Fed is likely to lower interest rates to a range between 4.25% and 4.50%, while signaling caution about further monetary easing.
Dot Plot Revision: The 2025 dot plot may indicate only three rate cuts, with even fewer cuts projected for 2026. This would give the December rate cut a hawkish tone.
Market Implications: A hawkish narrative may support the short-term strength of the U.S. dollar and pose challenges for equity valuations. However, strategic forecasts still favor equities for 2025.
It is widely expected that the Federal Reserve will cut interest rates by 25 basis points this week, bringing the federal funds rate target range to 4.25%-4.50%. As Fed decisions are increasingly data-dependent, investors will closely watch Chairman Powell’s tone during the post-meeting press conference, the updated Summary of Economic Projections (SEPs), and the dot plot, which shows expected interest rate levels for 2025 and subsequent years.
Rate Cut This Week: A Hawkish Cut?
Fed rate futures indicate a 95% probability of a 25 basis point cut at the December meeting, following a similar cut in November. This expectation may be driven by weakness in the labor market – the unemployment rate rose to 4.2% in November, and the labor force participation rate declined.
This labor market slowdown may justify further rate cuts to prevent excessive tightening. Additionally, a reduction in housing-related inflation is significant. Although inflation remains stubborn, new data indicates a decline in housing costs, a key inflation driver, facilitated by renegotiated rental agreements. This trend strengthens the case for additional rate cuts.
Although a rate cut is nearly priced in, the market will carefully watch for signals of a hawkish cut. Despite monetary easing, the Fed may indicate caution regarding the pace of future cuts through the updated dot plot or Chairman Powell’s remarks at the press conference.
Interest Rates for 2025: Will the Fed Pause Further Cuts?
There is increasing speculation that the Fed might skip a rate cut in January 2025, signaling a potential pause in monetary easing. Why might this happen?
While housing inflation is starting to decline, other inflation components remain persistent. This makes it difficult for the Fed to justify aggressive rate cuts. Additionally, recent data shows the economy’s surprising resilience, which may lead the Fed to adopt a more cautious stance on further easing. Furthermore, a new Trump administration, beginning on January 20, may focus on tariffs, potentially increasing inflation risks.
The dot plot, reflecting FOMC members’ interest rate expectations, will be crucial for market sentiment as it reveals the Fed’s outlook. The dots for 2025, 2026, and 2027 will indicate how aggressively the Fed plans to cut rates.
Outlook for 2025:
The previous dot plot indicated four rate cuts (totaling 100 basis points) for 2025. This may be revised to three or even two cuts due to persistent inflation risks. The consensus suggests the 2025 dot could shift from 3.375% to 3.625%, indicating three cuts. If it moves to 3.875%, signaling only two cuts, this would be a significant hawkish surprise for the market.
Long-Term Rates:
Projections for 2026 may also be revised to reflect only two rate cuts, indicating a slower normalization process. The consensus expects the 2026 year-end rate to be 3.125%, compared to 2.875% projected in September.
Terminal Rate:
The “long-term” neutral interest rate may rise to 3% from 2.875% in September, reflecting higher long-term rates.
Updated Economic Projections:
The SEPs are likely to show higher core PCE inflation for 2024 (up from 2.6% in September), a lower unemployment rate (down from 4.4%), and stronger GDP growth forecasts for 2024.
Market Implications and Portfolio Strategies
Equity Market Reaction:
Markets have already priced in a 25 basis point cut. However, if the Fed signals fewer rate cuts in 2025, risk assets like equities may experience higher volatility. A hawkish tone could pressure valuations, particularly for growth stocks sensitive to higher rates. Other rate-dependent segments, such as real estate developers and small-cap stocks, may also face challenges. Investors might shift funds to defensive sectors like utilities and consumer staples if the Fed indicates a slower pace of easing.
Fixed Income Positioning:
If the dot plot shows a higher terminal rate or fewer rate cuts in 2025, the yield curve may flatten. This means short-term yields could rise faster than long-term yields. Short-term bonds may face valuation risks as yields increase.
Forex Strategy:
A hawkish rate cut could support the U.S. dollar, boosting demand for the currency. Although seasonal factors and stretched positioning pose short-term risks for the USD, any declines may offer long-term buying opportunities. Pro-dollar policies under a Trump administration, such as stricter trade tariffs, could further support the USD in 2025. In contrast, the Japanese yen may weaken if U.S. 10-year yields rise, and tariff-related pressures may affect the Chinese yuan, euro, and Australian dollar.
Author: Charu Chanana, Chief Investment Strategist at Saxo
