The market entered the year expecting Federal Reserve officials to shift to a less dovish stance. Deutsche Bank entered the year saying the Fed would not cut at all and many expected the more hawkish FOMC members to at least float the idea of a long-term trip to the sidelines.
Instead, the message was ‘more cuts to come’. Fed Governor Chris Waller said on Wednesday that he would support further cuts in 2025 and that inflation would continue to move towards 2%.
Why is he being stubborn when the market has clearly rejected a rate cut?
Answer: Not stubborn, but practical.
Although the Fed has cut rates by 100 basis points since September, the market has not cooperated. Since then, two-year yields have risen 65 basis points and 30-year yields have risen 100 basis points.
It does not make the real economy easier, it makes it tougher. Now we could certainly debate the factors behind that and whether the Fed contributed to it through a policy error. I’d say it’s some combination of:
- The Fed is tapering too aggressively
- The economy is doing better than expected
- Election results lead to deficit worries
- Election results lead to tariff concerns
There are people who really want to debate each of these factors, but from the Fed’s perspective, it doesn’t really matter right now. The thing is that now the conditions for the real economy are stricter than in September.
The most obvious lever for this is the case, which is very sensitive to speed. The IYR Real Estate ETF is down 10% since its peak in September. While the homebuilder ETF is down 20%.
IYR ETF
There’s plenty of evidence that hot real estate markets are cooling, along with rents in those places. Similar dynamics played out in other rate-sensitive sectors.
The pain will eventually trickle down to businesses and consumers. That’s what looms as keeping the Fed cautious. With rates now near cycle highs, they have every reason to expect that some economic pain is in store.
So while they warmed to what looks like a poorly timed rate cut, what they actually delivered to the economy was a tightening. They can see it in the bond market, and increasingly in the stock market.
Mixed in with all that are some real policy uncertainties that are also keeping the Fed cautious. That said, don’t expect a true turn to neutral anytime soon.