The Federal Reserve and Chairman Jerome Powell's discourse clearly spooked the bond market on Wednesday. Markets had priced in 50 basis points in rate cuts next year, and that's exactly what Fed projections showed. But the market now sees just one quarter-point rate cut in 2025.
In other words, markets didn't believe what the Fed said, and the reason has seemingly everything to do with President-elect Donald Trump's agenda.
Federal Reserve Projections Soft-Pedal Trump Agenda
Powell has said that the Fed won't factor in the implications of Trump's agenda for monetary policy until it becomes clear what those policies are. Yet Wall Street isn't waiting. While the specifics are far from clear, lower taxes, higher tariffs and more deregulation are all very likely, as is tighter immigration policy.
Plugging in Deutsche Bank's assumptions, Matthew Raskin, U.S. head of interest-rate research, expects the U.S. economy to grow a solid 2.5% next year, as the unemployment rate slips just below 4%. By comparison, new Fed projections issued Wednesday see U.S. growth slowing to 2.1% as unemployment ticks up to 4.3%.
Ignoring Trump's agenda and its impact on the economy next year makes Wednesday's Fed projections of marginal value. Deutsche Bank, for its part, sees the Federal Reserve on hold all next year.
Trump Policy Uncertainty
Powell did note that some of the 19 Fed policymakers took preliminary steps to incorporate the impact of Trump policies, while others did not. Among those who did, Powell said, some identified "policy uncertainty" as contributing to a more uncertain inflation outlook.
Fed policymakers' projections for core inflation in 2025 ranged from 2.1% to 3.2%, vs the current 2.8% rate. The Fed's median projection for next year is 2.5%.
Powell's commentary was generally dovish. However, the high degree of policy uncertainty for the Fed is "not unlike driving on a foggy night," Powell said. "You just slow down."
At the moment, markets are leaning against another rate cut until the May 7 meeting. Even then, the odds are just 57% for a cut.
Powell noted that the Federal Reserve was able to look through any potential inflationary impact from Trump tariffs in 2018 and 2019, partly because of the low inflation backdrop. This time around, having gone through a multiyear period of elevated inflation, the Fed's approach could be different, Powell indicated.
"I wouldn't say that we know whether the last episode is or is not a good model," Powell said.
He seemed to imply that, barring labor market weakness, a stalling of inflation at elevated levels due to tariffs could impede additional rate cuts. "As we think about further cuts, we're going to be looking for progress on inflation."
10-Year Treasury Yield Flashes Yellow
The 10-year Treasury yield's surge "clearly suggests investors want a term premium for investing in longer term Treasuries," wrote Christopher Wood, Jefferies global head of equity strategy.
A term premium is the extra compensation bond investors require for holding long-term securities, rather than short-term. The term premium for Treasuries rises when investors get nervous about unwieldy deficits and rising debt levels.
The 10-year Treasury yield rose to 4.5% in the week following Trump's clean-sweep election on expectations of deficit-funded tax cuts. But Trump calmed the so-called "bond vigilantes" by selecting hedge fund manager Scott Bessent, a fiscal hawk, as his Treasury secretary and tapping Elon Musk and Vivek Ramaswamy to run the newly created Department of Government Efficiency.
This week's resurgence in the 10-year yield seems to show that markets aren't yet convinced by those appointments. Treasury yields' continued rise Thursday comes even after Musk and Trump both came out in opposition to the government's short-term funding bill that needs to pass by Friday night to avoid a shutdown.
The 10-year Treasury yield jumped eight basis points Thursday to 4.57%. It hit 4.59% intraday, the highest since the end of May. That's after spiking 11 basis points on Wednesday.
Brace For 'Sloppy' S&P 500
To some extent, the S&P 500 and bond market reaction to the Fed's rate cut on Wednesday looks like a perfect "sell-the-news" opportunity.
That's because, with the last assured Fed rate cut out of the way, the news flow is less positive. That's already happening with the rising risk of a shutdown, though the 10-year Treasury yield would presumably fall back if the government actually shuts down.
In a Thursday note, market strategist Ed Yardeni wrote that "the stock market might remain sloppy through January."
His list of reasons includes a potential longshoreman's strike in mid-January and "a blizzard of executive orders" on the first day of Trump's presidency, likely to involve tariffs and deportations.
Beyond that, Yardeni expects some profit taking into January after two great years for the market. He doesn't rule out a 10% correction but is keeping his 7,000 year-end target for the S&P 500.
The S&P 500 tried to bounce but ultimately fell 0.1% in Thursday's stock market action, after diving 2.95% on Wednesday. Nvidia and other megacap techs provided some support.
The S&P 500 on Wednesday closed 3.6% below its Dec. 6 all-time closing high, closing below the 50-day line for the first time in three months.
Be sure to read IBD's The Big Picture column after each trading day to get the latest on the prevailing stock market trend and what it means for your trading decisions.
