Fed tension limits scope for UST rally

Jerome Powell and his Federal Reserve (Fed) colleagues decided to cut the Fed Funds rate by 25bp to 3.75-4% at last week’s policy meeting, marking 150bp of cuts since the cycle began in September 2024. While the cut had been expected by the market, Powell pushed back on market pricing implying a further cut at December's meeting, describing it as far from a foregone conclusion. 

Indeed, the decision to cut by 25bp had two dissenters in Stephan Miran and Jeffrey Schmid, with the former voting for a 50bp cut and the latter voting to keep rates where they were. The tension on the policymaking Federal Open Market Committee (FOMC) had been clear in the Fedspeak that followed the September meeting, with inflation hawks worried about cutting into an economy that already has inflation around a percentage point above target battling with those more worried about the downside risks to the labour market. While the median member of the FOMC had pencilled in a cut at each of the last three meetings of 2025 (there is no November meeting), market pricing now puts the probability of a cut in December at around 66%, down from 100% before the meeting last week.

Part of the difficulty with moving in December is down to the lack of data the Fed will have in hand when making the decision. The Fed will have the "picture" of what's going on, according to Powell, but not the "detailed feel". So if the question for the more neutral members on the committee was whether the labour market was going to continue to weaken, and the data suggests (but doesn't necessarily confirm) sluggish but not weak labour growth, or uncertainty about the data remains high, then the Fed could well skip a meeting until that uncertainty clears.

The question for us is less about the sequence of cuts and more about the path. The dovish shift in September had been driven by a clear slowdown in jobs growth in the months prior, something that hasn't yet shown any signs of turning around. To a certain degree this has been for good reason. On the supply side, immigration growth has slowed significantly since Donald Trump became president, so the breakeven rate of payroll growth (the level of payroll growth that keeps the unemployment rate flat) has potentially fallen from around 150k a month to closer to 50k a month, while on the demand side factors such as trade uncertainty and even AI (at least at large cap level) are weighing on corporate hiring decisions.

Inflation, meanwhile, has in recent months printed below expectations. While there has clearly been a tariff impact in goods inflation, it has been lower than expected, and services inflation (particularly on the housing side) has continued to decline. In fact, Powell highlighted in his press conference that excluding the tariff impact (which the Fed puts at around 50-60bp) inflation is "not far" from their goal.

We think this keeps the Fed leaning dovish in the near term, and on balance we lean towards a December cut rather than not, but we expect the debate on the FOMC to intensify as we move through the early stages of 2026. While there are clearly some areas of weakness (sub-prime, labour etc.) economic activity remains robust and aggregate spending solid. While labour growth has been sluggish, layoffs have remained low. And while inflation has been better than expected, corporates have, as the Fed's own analysis suggests, so far only passed 35% of tariffs onto consumers.

Markets are currently pricing in a US terminal rate in this cutting cycle of 3%, around 20bp higher over the past couple of weeks and roughly in line with the median estimate of the neutral rate at the FOMC (though the range around that median estimate is 125bp). We think this is reasonably well anchored at the moment, particularly given the dearth of data but also because we expect labour growth to remain sluggish for a while longer. At close to 4%, the yield on 10-year US Treasuries therefore looks fairly priced and scope for a rally is limited in our opinion. The debate among FOMC members will become trickier next year, however, given expectations for stronger growth and inflation that is still likely to be near 100bp above target.