Stocks sell off and dollar spikes after Fed cut

What happened?

As expected, the Federal Reserve(Fed) cut rates by 25 basis points at its December meeting.

However, it surprised markets by slashing its forecast for rate cuts in 2025 in its “dot plot”, which shows that the Fed now expects only 50 basis points in cuts next year rather than the previous 100 basis points. Other notable changes to the dot plot:

• The Fed upwardly revised its expectations for inflation for next year. Core PCE, the Fed’s preferred gauge of inflation, is projected to be 2.5% by year end 2025, up from 2.2% in the Fed’s September dot plot.
• The Fed now expects gross domestic product growth — a key measure of economic output — to be 2.1% for 2025, up from September's forecast of 2.0%.

Chair Powell explained why the Fed cut rates today but downwardly revised forecasted cuts for next year. In short, it reflects the Fed’s attempts to achieve its dual mandate.

Chair Powell pointed to the Fed’s view that labor market conditions are cooler today than they were in 2019 – he mentioned it several times - hence today’s rate cut.

But disinflationary progress hasn’t been as significant as they would have liked, and they expect continued stickiness. Hence the major reduction in cuts penciled in.

Powell also mentioned that Federal Open Market Committee(FOMC) members believe there is greater uncertainty around future inflation because of uncertainty around the scope and timing of Trump administration policies.

How have markets reacted?

Treasury yields spiked, the US dollar spiked and stocks sold off.

What is our outlook on the situation?

Markets clearly had a visceral reaction to the surprise dot plot forecasts. But we have to remember that dot plots can be incredibly inaccurate.

In December 2021, the Fed’s dot plot anticipated less than 100 basis points in hikes for 2022. We subsequently got more than 400 basis points in hikes that year.

This is definitely a hawkish cut. On the bright side, the Fed has cut more than it did during the ’95-’96 easing cycle, when the US economy avoided recession and experienced strong growth. 

Ultimately, Fed policy will be driven by the data so we will need to focus on the data for the best insight into the path of monetary policy.

What is our resulting investment view?

Our outlook remains the same. As for now, we anticipate easing will continue, albeit more gradually, and that the global economy will re-accelerate next year.  That means our expectation remains that risk assets will perform well next year.

What are the risks to our view?

One of the swing factors that we discussed in our outlook – a resurgence of inflation – seems to have a higher probability of occurring. In particular, we have to worry about the Fed preemptively acting to cool inflation if FOMC members anticipate effects of Trump administration policies before they show up in the data.

One takeaway from this press conference is to pay close attention to the labor market going forward given Powell's multiple comments today. While loosening has been orderly thus far, the Fed is clearly concerned about it.

We also have to worry that the US dollar will be stronger than we anticipated. That could be create particular headwinds for emerging markets assets.

Investment risks

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.