Hawkish cut

The US Federal Reserve has cut interest rates for the third time in a row. At the same time, US Treasury yields rose significantly. We try to understand why.

All good things come in threes – the US Federal Reserve (Fed) has lowered the federal funds target range for a third time this year. As a result, US key interest rates are now in the range of 4.25 to 4.5 per cent.

If we are to believe the latest projections of the Federal Open Market Committee (FOMC), the central body responsible for US monetary policy, these three interest-rate cuts could mean that we are already at an advanced stage of the current interest-rate cut cycle. For the coming year, the members of the FOMC are only expecting two interest-rate cuts of 25 basis points (bps) each. According to the Fed’s current assessment, the US federal funds rate will still be above three per cent in 2027.

They provide the reasons for this assessment along with their other projections:

• On the one hand, inflation could remain slightly above the two per cent target. The Fed revised its September estimate for core PCE inflation in 2025 upwards by 0.3 percentage points. It now expects core inflation to be around 2.5 per cent next year.
   
• At the same time, the US economy continues to show resilience. Real growth of 2.1 per cent has been forecast for 2025 (up from 2.0 per cent in September). The unemployment rate is also expected to remain stable in the coming years at around 4.3 per cent, after reaching 4.2 per cent in November 2024.

We know from past experience that projections are often little more than a snapshot. This is also the case (or even more so) so close to the start of Trump’s second term in office. Regardless, these projections provide valuable information for determining the current situation. It is becoming clear that concerns about the US labour market and possible downside risks to the US economy have abated in recent months. This in turn reduces the pressure on the US monetary watchdogs to implement possible interest-rate cuts in anticipatory obedience. As a result, there is still a high degree of uncertainty regarding the future course of monetary policy. Nevertheless, today’s projections support the scenario of a “two-speed rate-cutting cycle”.

While the European Central Bank (ECB) is gearing its monetary policy towards a more neutral approach as early as next year, due to the weak economic momentum in the euro area, it does not seem far-fetched to assume that Powell and his team will continue to ‘travel high’ for a while longer, keeping rates relatively high.

How will the markets react?

The interest-rate cut of 25 bps did not come as a surprise. However, when it comes to bond prices and yields, market expectations for the future are more crucial. After the latest meeting, the Fed’s interest-rate projections for the coming year only foresee two (instead of a previous three) interest-rate cuts in 2025. As a reminder, as recently as September last year, expectations were for four cuts. In addition, the PCE core inflation forecast was revised upwards.

And thus, the latest Fed decision now marks a ‘hawkish cut’, i.e. an interest-rate cut that also signals a more restrictive monetary policy.

Yields on US Treasuries with maturities of two years rose by around 10 bps (as of Thursday noon, 19 December 2024). For 10-year bonds, the increase was as much as 15 bps.

Even though Treasuries lost value, the impact on an actively and intelligently managed bond portfolio was limited. Other securities, such as European bonds or government bonds from New Zealand, which have recently been rather weak in terms of growth, were more stable.

And in a mixed portfolio that includes equities as well as bonds, bonds are once again fulfilling their purpose. The US equity market in particular saw significant losses in the wake of the Fed meeting, as investors can no longer count on rising profits and falling interest rates. In terms of overall performance, bonds can cushion the losses of the equity component to some extent.