There are several reasons for adopting a cautious near-term outlook for markets, and reflation risk is arguably at the top of the list. That’s old news, but it’s a topic that’s keenly in focus after the Federal Reserve decided on Wednesday to cut interest rates for a third time.
The central bank, as expected, reduced its target rate by a quarter point to a 5.25%-to-5.50% range. Market reaction, however, was negative: Treasury yields shot up and stock prices fell sharply.
The 10-year Treasury yield surged to 4.52% yesterday (Dec. 18), the highest since May. Meanwhile, the S&P 500 Index sold off, dropping a hefty 3%.
There are several reasons why market sentiment should turn cautious. The Fed’s preference to downplay reflation risk is just the opening bid. There’s also growing uncertainty about how Trump 2.0 will affect the economic and inflation outlook. And suddenly there’s a new twist: government shutdown risk, which is lurking once again after President-elect Donald Trump on Wednesday railed against Congress’ plan to fund the government through March.
Current government funding runs out tomorrow (Dec. 20), when Congress adjourns for the holidays. The question is whether a new bill can be pieced together in the hours remaining before the federal government starts to furlough thousands of federal workers and reduce federal services tomorrow at midnight?
Meanwhile, investors are starting to recognize that while the US economy is humming along as 2024 winds down, moderate growth may be at risk, depending on how the president-elect’s plans for a policy shake-up unfold in the new year.
“The US economy is just performing very, very well, substantially better than our global peer group,” advised Fed Chairman Powell yesterday. The question is whether plans for sharply higher import tariffs, reduced regulations and tax cuts and deporting immigrant workers will enhance an already stable economic profile?
There are arguments on both sides of the debate, but there’s also more reason to wonder what’s coming in 2025. “It is a very uncertain outlook, and most of that uncertainty comes from potential changes in policy,” says Michael Gapen, chief US economist for Morgan Stanley.
It’s not obvious that the Federal Reserve’s rate cuts are helping sentiment at this point. The optics aren’t great for continuing to drop rates in the wake of recent signs that disinflation is stalling. The bond market is clearly unhappy.
Notably, the policy-sensitive 2-year Treasury yield shot up yesterday and has closed the gap relative to the Fed funds target rate for the first time in several years. The 2-year yield/Fed funds spread is now slightly positive, a clear sign that the market is calling for a halt to rate cuts, at least in the current climate.
Not surprisingly, Fed funds futures are now estimating a 90%-plus probability that the Fed will leave rates unchanged at the next FOMC meeting on Jan. 29.
It’s notable, too, that the Fed has reduced its outlook for rate cuts in 2025 to two from four in its September outlook. Meanwhile, the Fed raised its inflation forecasts, projecting PCE inflation will rise 2.5% next year, up from the previous 2.1% estimate.
“The Fed’s admitted uncertainty as to monetary policy actions in 2025, combined with the expectation of only two cuts (rather than four) in 2025 amplified investor uncertainty and concern, triggering profit taking this year versus delaying into the new year,” says Sam Stovall, chief investment strategist at CFRA Research.