As expected, the Fed cut rates by 25 basis points, but the Fed’s positioning regarding future rate cuts caught the market off guard. Looking back, it was somewhat obvious. Earlier yesterday, I shared a video highlighting how analysts were expecting more rate cuts than what the Fed Funds Futures and overnight swaps markets were pricing in. Historically, in my experience, the FOMC aligns more closely with Fed Funds and swaps markets than with analysts’ expectations, so the analysts seemed overly optimistic.
We may see fewer—or potentially no—rate cuts next year. The Fed swaps market is currently pricing in just one rate cut for next year, with the odds of more than two cuts essentially at zero. Currently, the market projects the Fed Funds rate to end 2025 around 4%, which implies just one more small rate cut. This marks a significant shift from where expectations stood three to six months ago—or even last year.
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The 2-year Treasury yield, currently hovering around resistance at 4.35%, could rise significantly. A breakout above 4.35% might push it towards 4.61%.
Meanwhile, the 10-year yield, now trading at 4.52%, is breaking out and could reach 4.75% or higher. Ultimately, if Fed Funds settle in the upper 3% range and you add a premium of 2–3% above Fed Funds, the 10-year yield could approach 6%. Similarly, the two-year yield in the high 4% range suggests another 200 basis points higher for the 10-year, reinforcing the potential for it to reach 6%.
The dollar strengthened sharply yesterday, hitting 108, its highest level since November 2022. This puts the Bank of Japan in a bind ahead of its policy decision tonight.
The Japanese yen, which is weakening against the dollar, has risen to 155. I doubt the BOJ wants further yen depreciation, so it may be forced to either raise rates or adopt a hawkish tone on future rate hikes.
This scenario continues to reflect the higher rates, stronger dollar, and tighter financial conditions we’ve discussed before. Credit spreads also widened significantly yesterday. The CDX High Yield Credit Spread Index rose 17 points to 315—still low by historical standards but much higher than the sub-400 levels of a year ago. A widening in credit spreads typically translates to higher earnings yields on the S&P 500, which could lead to multiple contractions.
The S&P 500 dropped 3% yesterday, closing below 5,900. If the index breaks this level, it could decline into the 5,600s.
The VIX also spiked, ending the day at 27.6—up 12 points. The one-day VIX rose 32 points to 45.75, signaling sharply higher implied volatility. Realized volatility is also climbing, with the 10-day measure rising to 17.5, the 20-day to 13.5, and the 30-day to 12.
Small caps had a rough day, falling 4.5% and erasing all their post-election gains. The Russell 2000 is now back to November 2023 levels. Regional banks dropped about 5%, and the housing sector also saw significant declines, with the Philly Housing Sector Index (HGX) down almost 4%.
Finally, the three-month forward rate (18 months out) rose to 4.40% yesterday, above the three-month Treasury spot rate for the first time in a long while, This marks the end of a prolonged period of inversion since the fall of 2022. The curve’s uninversion may further signal that the Fed’s rate-cutting cycle has concluded, as it closed above 0% at 0.06% yesterday.