Recap | Fed's Hawkish Cut and Market Sell-Off

The Federal Reserve, in its December meeting, delivered exactly what the market had predicted: a 25-basis-point cut to interest rates. Yet, instead of celebrating the anticipated move towards easier monetary policy, markets threw a tantrum. Stocks tumbled, bond yields soared, and volatility spiked – all on the back of a move that everyone knew was coming. What went wrong?

The answer lies not in the cut itself, but in the details and the message that accompanied it. It turns out, the market wasn't just after a rate cut; it was also hoping for a signal that the Fed would continue easing aggressively throughout 2025. That's where the Fed's communication went awry.

The Dot Plot Disappointment

The source of the market’s disappointment was the Fed’s Summary of Economic Projections (SEP), particularly the "dot plot."

The Fed's dot plot is a simple but important chart released as part of the SEP, which accompanies some FOMC meetings. It visually represents each FOMC member's anonymous projection for the appropriate federal funds rate (the key short-term interest rate the Fed controls) at the end of the current year, the next few years, and in the longer run.

The dot plot released last week showed a notable shift in expectations for future rate cuts. Compared to the September projection, the median forecast now suggested only two 25-basis-point cuts in 2025, down from four previously. This was a major factor in the market's negative reaction.

Additionally, the range of projections broadened, with more dots appearing higher up on the chart, revealing increased disagreement among FOMC members about the appropriate path of monetary policy. The most dovish Committee member projected a rate 125 bps lower than the current level by the end of next year, while the most hawkish member anticipated no change. This divergence in views underscores the uncertainty surrounding the economic outlook and the challenges the Fed faces in balancing its dual mandate of price stability and maximum employment.

Inflation Worries Resurface

Adding to the market’s unease was the Fed’s updated inflation outlook. The 2025 core inflation forecast was raised from 2.1% to 2.5%, a notable increase that fueled concerns about persistent price pressures. While Fed Chair Jerome Powell acknowledged recent inflation data had come in higher than anticipated, he stopped short of explicitly attributing the revised forecast to potential inflationary impacts from the incoming Trump administration's policies.

However, he did confirm that some policymakers had begun incorporating highly conditional estimates of these potential policy effects into their individual forecasts, leaving markets to speculate on the extent to which these considerations influenced the overall outlook. This ambiguity, coupled with the upward revision, further rattled investors already unnerved by the less dovish dot plot.

Market Reaction

The market’s response was swift and severe. The 10-year Treasury yield – a key benchmark for borrowing costs – surged 10 basis points, marking its sharpest one-day jump on an FOMC announcement since the infamous "Taper Tantrum" of 2013. Stocks were hammered, with the S&P 500 plummeting nearly 3% in a single session. The volatility underscored just how far apart the Fed and the market were in their expectations for future policy.

What Wall Street Thinks

UBS: "The Fed is likely to want to see lower rates of core inflation before it cuts interest rates further. We continue to believe that high grade and investment grade bonds, diversified fixed income, and equity income strategies are valuable in a portfolio context. Overall, while 'positioning for lower rates' may no longer be as urgent, putting cash to work and seeking durable income should remain a strategic priority for investors."

Goldman Sachs: "The Fed leadership appears to share our dovish economic views that inflation is headed back to target and that labor market cooling still merits attention, and does not share the view some participants have voiced that the funds rate might be close to neutral — Powell said four times that policy is still 'meaningfully restrictive.' But other Fed officials proved to be more hawkish than we anticipated, and it seems increasingly possible that the risk or realization of tariffs could restrain the FOMC from cutting."

Wells Fargo: "This week's FOMC meeting leads us to believe that, barring some dramatic unexpected development, the Committee likely will keep rates on hold at its next meeting on January 29. However, we believe the FOMC will continue to ease policy next year, albeit at a slower pace than over the past few months. Chair Powell seemed to support this expectation when he noted in his presser that the stance of monetary policy is 'significantly closer to neutral' than it was previously, but that policy is 'still meaningfully restrictive.'"

Other Macro Developments

1. China Sees Record Capital Outflows: China experienced a dramatic surge in capital outflows in November, reaching a record US$45.7 billion, according to official data. This exodus of funds from Chinese stocks and bonds reflects growing investor concern about the country's economic outlook. The move comes as the Chinese central bank has increased support for the yuan, suggesting worries about potential currency weakness.
2. Yen Weakened by BOJ and Fed Decisions: The Japanese yen fell to a five-month low against the dollar following the Bank of Japan's decision to hold interest rates steady. This came on the heels of the Fed's rate cut and cautious outlook, exacerbating the interest rate differential between the two countries. (Source: Nikkei Asia)
3. Cocoa Dominates Commodity Markets: Cocoa has emerged as the undisputed champion of the commodity market in 2024, boasting gains dwarfing all other major commodities. Prices have nearly tripled this year, driven by a perfect storm of tight supply due to faltering production in West Africa, unfavorable weather, and a virulent crop disease. Cocoa even outperformed Bitcoin this year.
4. Italy's Bonds Shine: Italian government bonds are attracting investor interest due to the country's relative political stability compared to the economic and political turbulence in Germany and France. The yield spread between Italian and German bonds has narrowed considerably.
5. UK Manufacturing Output Plunges: British manufacturers reported their sharpest fall in output since the COVID-19 pandemic, driven by weakening external demand and declining domestic business confidence following the recent budget. This adds to growing concerns about a slowdown in the UK economy.