Markets reacted strongly to a surprise change in dot plot forecasts by the US Federal Reserve on Wednesday evening.
US Treasury yields rose, stocks sold off and the US dollar strengthened as the Fed indicated it would only cut by half a percentage point in 2025.
This was only half of what US central bank members projected in its last forecast during the September FOMC meeting, marking a major shift in policy expectations going into next year.
“This is another meaningful shift in the Fed’s framing that just three months ago prompted a 50-basis point cut,” said Jean Boivin, head of the BlackRock Investment Institute.
“But this shift is in line with what we have been flagging: persistent inflation pressures would prevent the Fed from carrying out the easing cycle markets were hoping for.”
BlackRock has been expecting the Fed to recalibrate policy – taking it from restrictive to less restrictive.
Boivin said: “This is exactly what is coming to light, with Fed Chair Powell implying that the central bank may put an end to its consecutive cuts by pausing as soon as its next meeting in January.”
Indeed, Powell said in his remarks that the Fed is “at or near a point at which it will be appropriate to slow the pace of further adjustments”.
Given that the US central bank also revised inflation expectations for next year upwards, Boivin suggested policy rates could in fact be closer to neutral than markets think.
He said this change does not change the firm’s positive view on US equities, since they will still benefit from AI, robust economic growth and broad earnings growth.
However, Jack McIntyre, portfolio manager at Brandywine Global thinks that this policy uncertainty will create more volatile conditions in 2025.
He said: “The longer it persists, the more likely the markets will have to equally price a rate hike versus a rate cut.”
“The results of this meeting raise the question: if the market wasn’t expecting a rate cut today, would the Fed actually have delivered one? I suspect not.”
“Not surprisingly, there was a dissenter. Thus, the Fed has entered a new phase of monetary policy, the pause phase.”
Risk assets still on track to perform in a strong economy
A pause in rate cuts may be a sign that the economy is on good footing, a stark contrast to 18-months ago when a global recession was the broad consensus.
Tai Hui, APAC chief market strategist, J.P. Morgan Asset Management said: “The U.S. economy shows resilience, with growth tracking around 3% for the fourth quarter and a labour market that is cooling but stable.”
He said: “Going into 2025, sustained economic growth in the US and further rate cuts should still support risk assets, such as equities and corporate credits.”
“However, the widening range of possible outcomes from the incoming Trump administration, presenting both upside and downside risks to the economy and corporate earnings, should require investors to take a more diversified approach in asset allocation.”
David Chao, global market strategist, Asia Pacific (ex-Japan) at Invesco said investors need to remember that “dot plots can be incredibly inaccurate”.
Indeed, during the December 2021 Fed dot plot, less than 100 basis points in interest rate hikes were expected for 2022.
Interest rates subsequently increased by over 400 basis points that year, partly due to the inflationary pressure caused by the Russia-Ukraine war and oil price shock.
Chao said that, “Ultimately, Fed policy will be driven by the data so we will need to focus on the data for the best insight into the path of monetary policy”.
He said: “One of the swing factors that we discussed in our outlook – a resurgence of inflation – seems to have a higher probability of occurring.”
“In particular, we have to worry about the Fed pre-emptively acting to cool inflation if FOMC members anticipate effects of Trump administration policies before they show up in the data.”
Despite these risks, Chao said he still expects risk assets to perform well next year as the economy re-accelerates.
But he warned investors need to watch for the impact of a stronger US dollar. “That could be create particular headwinds for emerging markets assets,” he explained.
