A Loose Anchor

10 December 2025

The prevailing bias is that the US Federal Reserve will cut the funds rate at the December FOMC on Wednesday. However, many investors anticipate “hawkish language.” From our vantage point, the description of a “hawkish cut” is self-contradictory. If the Fed cuts rates that will ease the cost of borrowing at the front end of the yield curve.  To be fair, the US is a “long rate” economy – most borrowing is done at the long end of the yield curve. Hence some investors fear that cutting the funds rate when inflation is around 3% (and above the Fed’s target) might contribute to higher inflation expectations and long dated Treasury yields. Put another way, the rate cuts might be self-defeating.

Markets are forward looking and the anticipated rate cuts by the Federal Reserve has already eased broad financial conditions over the past few months. That partly explains the divergence between economic confidence surveys and asset markets that reflect financial conditions (equity prices, and credit spreads (chart 1). Long term Treasury yields ought to reflect the future expected policy rate plus a premium for inflation and term to maturity risk. US 30-year Treasury yields are higher than when the Fed commenced the rate cuts in September 2024 (chart 2). In turn this has prevented mortgage rates from falling meaningfully. The challenge for the Fed at the December meeting and looking forward into 2026 is that inflation remains at 3% and above the Fed’s target, especially if growth re-accelerates on easy financial conditions, capital spending, and loose fiscal policy.

Chart 1

Source: Bloomberg

Chart 2

Source: Bloomberg

The cyclical bear case and the bullish case for bond prices (lower yields) next year is signs that there is material weakness in the labour market. Moreover, as we have noted recently, both University of Michigan and Conference Board measures of consumer sentiment is consistent with other leading indicators of employment. If the labour market deteriorates sharply an acceleration in consumer price inflation is unlikely next year and that would permit the Fed to cut the funds rate by more than is currently priced into the forwards. Optimists argue that labour market is likely to be moderately weaker, rather than acutely weaker (non-linear rise in unemployment). The bullish set up for equities is an acceleration in earnings on easing financial conditions, capital spending, fiscal support, and Fed easing on moderate weakness in the labour market.

A robust cyclical re-acceleration in growth (an economy that is too hot) might be equally challenging for long duration assets including equities if that leads to a renewed rise in consumer price expectations and a wider bond risk premium. The price action in long bonds (higher yields) or the way price is behaving suggests that the 30-year Treasury is contemplating that risk. In this region a higher path for US rates might lead to renewed dollar strength as well.  If growth re-accelerates additional Fed rate cuts might be self-defeating. Our sense is that labour market weakness is likely to mitigate inflation risk. However, the message from Mr Bond is that markets will fear a loose (Fed) anchor.

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