The Federal Reserve’s dovish pivot a year ago set the stage for expectations of an aggressive easing cycle, briefly interrupted by a bout of sticky inflation in early 2024. At the time, the upper bound of the federal funds target rate was 5.50 per cent – well above the US central bank’s favored inflation measure (personal consumption expenditures price index, or PCE), signaling a highly restrictive policy.
The Fed’s December rate cut of 25 basis points came with a less friendly policy outlook. A resilient US economy and the anticipation of pro-growth policies under the incoming Trump administration have tempered expectations of further rate cuts in 2025, from four to two. While the December cut to 4.5 per cent was widely expected by the market, so too were modest upward revisions to the central bank’s Summary of Economic Projections. However, the extent of these adjustments stood out as the biggest takeaway from this meeting.
While Fed Chairman Jay Powell noted that the central bank’s dual mandate—managing inflation and employment—remains “roughly in balance,” the bias appears to have shifted toward managing inflation risk. The inflation forecast has risen from 2.1 per cent to 2.5 per cent, and the unemployment rate is expected to edge down from 4.3 per cent to 4.2 per cent.
With no signs of a slowing economy, there is heightened risk that progress on inflation could stall, injecting volatility into mid- to longer-dated bonds. Meanwhile, the US faces mounting federal debt, with interest payments exceeding defense spending in 2024. The sizable deficit raises concerns about upward pressure on long-term rates, especially with US$ 9 trillion in debt that needs to be refinanced in 2025. Adding to the uncertainty are questions surrounding the policy priorities of the incoming administration.
Policy forecasts at this stage are highly speculative, but they do not appear to spell disaster for the US economy or markets in the short run. If 25% tariffs were enacted as proposed, they could drive higher inflation, dampen overall demand, drive up interest rates, and strengthen the US dollar. A recent estimate from Yale’s Budget Lab[1] suggests these tariffs would raise consumer prices by 1.4 per cent to 5.1 per cent before substitution effects take hold. Tax cuts would not impact GDP in 2025 but would be a factor in 2026. While job growth would be relatively unaffected in 2025, labor markets would tighten, and slower labor force growth due to reduced immigration would cut the unemployment rate by the end of 2025. The potential for tariffs this year, combined with fiscal thrust in 2026, could prompt the Fed to end the easing cycle prematurely.
Another way to look at this is through the components of bond yields, which can be decomposed into two primary factors: expectations of the future short-term rates and a term premium, which reflects the compensation investor demand to hold riskier longer-term bonds. With rate expectations anchored by Federal Reserve policy guidance, most of the recent increase in longer-term Treasury yields is due to shifts in the term premium.
While term risk premiums have been low by historical standards, the recent increase suggests investors are pricing in a potential regime change toward higher interest rate levels than have been the norm over the past two decades. This suggests that the equilibrium level of the US 10-year Treasury yield over the next year should settle between 4.5 – 4.75 per cent. For 2025, we expect the US 10-year to trade within a range of 4.3-4.7 per cent.
[1] Yale Budget Lab, “Fiscal, Macroeconomic, and Price Estimates of Tariffs Under Both Non-Retaliation and Retaliation Scenarios,” October 16, 2024
Independent Opinion
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