Weekly market wrap

The Federal Reserve plays Grinch on rate cuts for 2025

Key Takeaways:

• At its final meeting of 2024, the Federal Reserve caught markets off guard with a hawkish tilt to its updated economic projections and "dot plot" (FOMC voting members' median estimate on path of rates).
• While the Fed did cut rates by 0.25%, bringing the fed funds rate to 4.25% - 4.5%, the dot plot indicated only two rate cuts in 2025, below the September estimate of four rate cuts. Markets initially reacted negatively, with bond yields moving higher and stocks moving sharply lower.
• The Fed pointed to two reasons for its more cautious approach to rate cuts – the outlook for inflation and the unknowns around tariff policy in the year ahead.
• Nonetheless, Fed Chair Powell also reiterated that the Fed sees the U.S. economy as strong and "in a really good place." We believe the fundamentals of the economy are sound, and market volatility continues to be an opportunity for long-term investors.

The Fed delivers a modestly hawkish outlook at its final meeting of 2024

Overall, the December FOMC meeting pointed to a Fed that wanted to proceed with a bit more caution on the path of rate cuts. The Fed cut rates by 0.25% to 4.25% - 4.5%, but its dot plot indicated just two rate cuts in 2025, versus four rate cuts penciled in at the September FOMC meeting.

As Chair Powell noted, the Fed has already cut rates by one full percentage point, from 5.5% to 4.5%, which has brought them meaningfully closer to a more neutral rate. The Fed believes it can be more gradual on rate cuts, and it pointed to two sources of uncertainty:

1. The path of inflation: The Fed noted that inflation has come down substantially in the last two years but still remains elevated versus its 2.0% target. The Fed continues to see inflation moderating, but at a slower pace. Its updated projections now show core personal consumption expenditure (PCE) inflation falling to 2.0% by 2027.
2. Uncertainty around government policy, particularly tariffs: Powell alluded briefly to potential changes in trade and tariff policies, which could have an impact on inflation as well. However, he also noted that there are still too many unknowns around the new policies to make a definitive conclusion on inflation estimates.

Our take: We believe the Fed's more cautious approach to rate cuts are somewhat warranted, given that inflation remains above 2.0% (although contained, in our view) and that there are uncertainties over tariff policies. However, the direction of interest rates is lower over the next 12 months. This should be supportive for both consumption and household and corporate borrowing costs.

In addition, markets had already been pricing in just two rate cuts for 2025, so the Fed's updated dot plot brings it in line with market expectations, though markets are now pricing in just one Fed cut in 2025, according to CME FedWatch tool. In our view, with this reset in market expectations, the Fed now has more room to surprise markets with more cuts than anticipated, which could support market sentiment as well.

We believe the fundamentals remain intact

Perhaps the other key takeaway from this week's FOMC meeting is that the Fed believes both the U.S. economy and the labor market are in good shape, and this was reflected in its updated projections. Powell noted at the press conference that he is "very optimistic about the economy."

The new Fed forecasts pointed to better economic growth and a lower unemployment rate versus September estimates. The projections showed U.S. GDP growing by 2.1% in 2025, compared with 2.0% at the September meeting. In addition, the unemployment rate is now expected to be 4.3% for 2025, versus 4.4% at the September FOMC meeting. Overall, the resilience of the U.S. economy should provide the Fed with some comfort that consumers have been able to withstand the restrictive policy stance thus far.

The Fed's December projections pointed to better economic growth and lower unemployment in 2025:

Our take: The ongoing bull market has been driven by a strong economy, solid earnings growth, and a consumer that has remained resilient, even in the face of higher rates and elevated inflation. Last week's Fed meeting did not change this narrative. In fact, the Fed gave further confirmation that the economy is in good shape, inflation is contained, and it plans to move interest rates lower from here (albeit at a slower pace than originally planned).

The economic data released last week also underscored a strong U.S. economy. The third-quarter annualized GDP figures came in at 3.1%, above forecasts of 2.8%, driven by healthy consumption of 3.7%.* The Fed GDP-Now forecast also calls for fourth-quarter U.S. GDP to come in around 3.2% annualized. This data confirms that U.S. economic growth is on pace to end the year above trend, which is typically in the 1.5% - 2.0% range.

Market volatility is not surprising after a strong run and should not rattle long-term investors

After a 27% gain in the S&P 500 through Monday last week, it is not surprising to see some pullback in markets, particularly as we head into year-end and investors are thinking about profit-taking, rebalancing, and tax-loss harvesting.

Keep in mind that even with the pullback we saw after the Fed meeting last week, the S&P 500 is still up about 24%, and the less tech-heavy Dow Jones Index is up about 14%. From peak to trough, the decline in the S&P 500 was about 3.5% and about 6% for the Dow Jones, indicating that both indexes experienced corrections of less than 10%, which are common in most years.*

Bond yields have also moved higher, with the 10-year U.S. Treasury yield now above 4.5%.* This move has been driven by a combination of shallower rate-cut expectations, and higher economic growth and inflation prospects. Nonetheless, for balanced investors, these elevated yields could present an opportunity to consider gradually moving any outsized positions in cash into the investment-grade bond market, particularly into seven- to 10-year intermediate bonds.

More broadly, long-term investors in the market should take comfort that despite the volatility of last week, not much has changed from a fundamental perspective. Markets will most certainly face new "walls of worry" next year, including uncertainty around government policy and Fed policy, but we believe the underlying drivers of the bull market remain in place (as also outlined in our 2025 Annual Outlook). In this backdrop, investors can continue to use bouts of volatility and pullbacks as opportunities, to diversify, rebalance, and add quality investments in both stocks and bonds – in line with your personal risk tolerances and goals – even if the Fed cuts rates at a more gradual pace in the year ahead.

Mona Mahajan
Investment Strategy

Source: *FactSet

Weekly market stats

^{Source: FactSet, 12/20/2024. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results. *Morningstar Direct 12/21/2024.}

The week ahead

Important economic releases this week include new home sales and consumer confidence.

Review last week's weekly market update.