How much will the FED cut rates by year-end?

Market confidence has increased following a very underwhelming non-farm payroll report last week. But the problem faced by the Fed was laid bare again by the fact that such paltry employment growth in the last three months has not lifted the unemployment rate. This reflects the fact that labour supply is falling at the same time as the decline in labour demand. It seems likely that the harsh crackdown on illegal migration has had a role in reducing labour supply.

The Fed cannot influence labour supply; only demand. And, if supply is weak, there is little justification for the Fed to try to boost demand by cutting rates; indeed, it could prove counterproductive by pushing up wages and inflation. At the same time, inflation continues to edge higher but unlike the inflation in the postpandemic period, this inflation is in goods, not services.

As long as that stays the case the central bank seems likely to try to ‘look through’ the temporary rise in prices caused by tariffs and cut rates. But this too could prove a mistake if the biggest threat to long-lasting inflation is not from tariffs but from much weaker migration flows. If all this is not enough, there is the added problem of political pressure on the Fed to cut rates from the President, and now the composition of the FOMC will change because President Trump has the opportunity to replace Governor Kugler who has quit her post five months early.

Steven Barrow, Head of Standard Bank G10 Strategy, said the Fed would make just one rate cut this year, probably at the December meeting and then take rates down to a base of 3.75% next year. “While we can still see the Fed waiting until later in the year to ease, the cost of delay is likely to be that the landing point in the easing cycle will be lower than previously envisaged and this landing point could come sooner in 2026 than we had envisaged. We now look for the base of the easing cycle to be at 3.25%; a level that we expect to be achieved in the spring of next year”, said Steven Barrow.

As for treasuries, there is a clear risk that yields at the front end of the curve run far ahead of Fed easing, so producing even more inversion between the fed funds rate and 2-year yields. The Standard Bank lowered its longer-term yield forecasts as well but still has residual concerns here about issues such as structurally higher inflation, budgetary largesse, political pressure on the Fed and more. In short, the 2s-10s curve is expected to steepen even as 10-year yields fall to around 3 ¾% in Q1 next year.

The Fed faces the vexing problem that the economy appears to be weakening at the same time as inflation is rising. The Bank of England faces the same scenario. The Bank of England voted by a fine margin to cut interest rates from 4.25% to 4% on Thursday as the central bank resumed what it describes as a “gradual and careful” approach to monetary easing. For while the US faces a rise in inflation (from tariffs) that may prove unresponsive to weaker growth, the UK’s poor economic performance should have a more material impact on prices. But like the US, the bond market could prove vulnerable to inflation concerns as well as fiscal fears. The UK faces a ’doom loop’ in which economic weakness forces immediate pressure on the government to improve the budget and this, in turn, makes the economy fall still further. It is imperative to break this cycle.

The best way, of course, is through an autonomous improvement in the economy, helped by lower base rates, for instance. But Steven Barrow is not sure that this will happen and that could force the government into an embarrassing climbdown on its cherished fiscal rules which basically seek to plan for reduced debt as a proportion of GDP and for everyday spending to be covered by revenues. These are not easy targets and, with the government rather straightjacketed into this situation, Steven Barrow believes that other bond markets, in the eurozone for instance, represent better value.