Prospects for the Fed’s rate cuts

The Fed kicked off what is likely to be a second round of rate cuts after the nine-month hiatus between December 2024 and the FOMC’s recent meeting. The 25-bps rate cut should prove a modest downpayment on what is to come as the Fed pushes the target towards 3% over the next 6-9 months. It is what the equity and treasury bulls wanted to see, but they should be careful what they wish for.

Recent easing cycles from the Fed have often followed adverse shocks, like the financial crisis or Covid-19 when growth and inflation decline together. Of course, the Fed started easing policy in 2019 before Covid really started, but that was also when inflation was falling. Given this backdrop, the implication for bonds and stocks was pretty clear at the time, as both rallied with policy easing. But now growth and inflation seem to be going in opposite directions. This makes life harder for the Fed and harder for financial markets.

For even if the short-term response to lower policy rates is a stronger stock market and lower bond yields, there’s no guarantee that such a reaction can endure, even if the Fed keeps rate cuts coming. In fact, when it comes to treasuries, we could get into a situation where the more the Fed cuts, the worse the performance of longer-term bonds becomes. For not only is there the stagflationary problem to bear in mind, which includes the prospect of higher inflation, but there is also the whiff of political pressure from the Trump Administration to lower rates in order to bring the government’s interest bill down.

For the moment, though, these concerns may take a back seat. Politicization of the Fed is still a work in progress, as only White House economist Miran is on the Board. And besides, such is the scale of the revision to past employment data and the paucity of the tariff-driven inflation rise that the Fed was likely to cut rates even without these deeply disturbing political undertones.

Unless price data perks up quickly, many analysts say that the FED’s next few rate cuts will be mostly uncontroversial. Indeed, it is very possible that the Fed gets all of this easing cycle done before Powell hands over to his Trump-nominated successor next May. But none of this takes anything away from the seriousness of the political pressure on the Fed and hence the risks to the longevity of any equity and bond rallies.

Steven Barrow, Head of Standard Bank G10 Strategy, believes that future inflation pressure won’t be as benign as the market expects. The 5-year forward starting 5-year inflation swap is just below 2.5%. That’s lower than when Trump won the election and also lower than when he came to office in January. Even the rise in these inflation expectations since the infamous ‘liberation day’ tariff announcement on April 2^nd has been little more than a tenth. This seems pretty incredible when you consider that this period has seen the US’s effective tariff rate rise from under 3% to around 15%.

It is perhaps even more incredible when you think that ICE has not just been exporting undocumented migrants at a rapid pace, but instilled fear in many who have the correct papers. Industries that rely on migrant workers, like the crucial agriculture and housing sectors will feel the weight of their departure and we are already starting to see this come through in data such as rising fresh vegetable prices and falling house permits.

Steven Barrow thinks that 5yr forward starting 5yr inflation swaps should at least have a 3-handle, if not more. If the market thinks that tariffs and deportations won’t lift inflation it could be because investors feel that other factors will counterbalance any price pressure. But what are these factors? One is much weaker demand in the economy, but that’s not necessarily a great news story for equities. Of course, the Fed could ease any burden for now with more rate cuts to supercharge the equity rally even more but this may just serve to postpone the day of reckoning if inflation becomes too elevated and the Fed is under pressure to start tightening again in 2027. For if that’s the case, this is when the real politicisation of the Fed will become clear.