The Fed Decision: Higher Growth Comes at A Price

Economic

Summary:

Global Head of Fixed Income Jim Cielinski and Head of Global Short Duration Daniel Siluk discuss how the Federal Reserve’s (Fed) December decision illustrates that sustained U.S. economic growth comes at the price of a higher rate trajectory.

On Wednesday, the Federal Reserve (Fed) provided additional proof points to what the market had been pricing since September: The U.S. economic cycle is extending, and while that is likely to benefit riskier assets, the landscape for many pockets of the fixed income market is becoming less certain.

Starting with the Fed’s dovish pivot exactly a year ago – and only briefly interrupted by a bout of sticky inflation in early 2024 – expectations were for an aggressive easing cycle. The upper bound of the federal funds target rate – 5.50% at the time – was well above the U.S. central bank’s favored inflation measure, signaling highly restrictive policy.

The Fed’s 25 basis-point (bps) rate cut was not much of a gift, as it was accompanied by a less friendly policy outlook. A resilient U.S. economy, along with the pricing in of pro-growth policies by the incoming Trump administration, has flipped the “accommodation” script. The cut to 4.5% this week had been widely expected by the market. Also expected were modest upward revisions to the central bank’s Summary of Economic Projections. The degree to which many of these expectations were adjusted, however, may have been our biggest takeaway from this meeting.

In monitoring these statements, it’s important to identify potential incongruities between general rhetoric and the details. While Fed Chairman Jay Powell spoke to both sides of the central bank’s dual mandate being “roughly in balance,” we believe the bias has again shifted toward managing inflation risk.

By the numbers

In the Fed’s updated projections, the revision to real economic growth as measured by gross domestic product (GDP) confirmed what most already knew: At a 2.5% clip in 2024, the U.S. remains in the class of advanced economies.

Sturdy U.S. growth was reflected through a modest bump in 2025 and 2026 GDP expectations and a slightly lower unemployment rate for 2024 and 2025. Chairman Powell was quick to reiterate that a resilient labor market was a welcome development and that he did not expect wages to be an upward force on inflation.

The most notable revisions were in higher inflation projections. For 2025 and 2026, headline inflation as measured by the Personal Consumption Expenditures Price Index was upwardly revised to 2.5% and 2.1%, respectively. Core inflation for those two years is now expected to clock in at 2.5% and 2.2%, respectively. By this measure, the Fed only expects to hit its inflation target of 2.0% in 2027.

Here we would highlight the core services component of inflation. We believe the Fed may be concerned that this key input to overall price stability may be bottoming well before inflation has reached its target. By this rationale, maintaining a dovish stance could extinguish recent progress on inflation.

Behind the “dots”

Also of note were revisions to the Fed’s expectations for its policy path. Much of the previous dovish trajectory had already been taken off the table. That trend continued, with this iteration of the survey now projecting only two cuts in 2025 (down from four) and an additional two in 2026, in line with earlier estimates. Importantly, the terminal rate for this cycle is expected to be 3.0%. Only a year ago, the call was for 2.5%.

What’s behind the expectations for the shallower rate path is important. If driven by anticipation of higher economic growth due to a business-friendly agenda, that’s positive for markets. If, however, the more inflationary components of the incoming U.S. administration’s agenda – e.g., tariffs – necessitate higher policy rates, investors would rightly be concerned about volatility along mid-to longer-dated points of the U.S. yield curve.

Markets in motion

The range of potential outcomes for bond markets has widened. A cycle extension in the U.S. comes with the risk that progress on inflation could stall, injecting volatility into mid- to longer-dated bonds. Uncertainty about the incoming administration’s policy priorities further clouds the picture. Thus far, the U.S. economy has nailed the elusive soft landing. Firming economic growth could keep the party going – or it could reset consumers’ inflation expectations to a higher range, forcing a rethink of underlying assumptions by the Fed.

Typically, investors would welcome a return of a term premium in the U.S. Treasuries curve. But that incremental bump in yields between the 2-year and 10-year notes – currently about 15 bps – is a reflection of rising uncertainty around U.S. inflation and the appropriate policy response. Investors must decide if that incremental yield is worth the risk.

Valuations matter, too. A cycle extension should benefit quality corporate issuers. But the yields on many of these securities relative to their risk-free benchmarks are narrow by historical standards, leaving little cushion to protect against rate volatility. While defaults are low and a growing economy should help corporations maintain coverage ratios, we believe securitized credits represent a better opportunity at present given more attractive valuations and the potential for their underlying assets to appreciate.

The Fed’s updated projections affirm that, globally, economic growth and policy responses are diverging. Upwardly revised rate expectations mean that the U.S. remains an attractive destination for yield. Conversely, weakness in Europe and other jurisdictions is likely to result in additional policy easing and lower rates. Furthermore, several pockets of the global credit market currently trade at discounts to similarly rated U.S. peers.

Conclusion

The era of synchronized bond markets and meager yields is over. This presents an opportunity for investors to fortify broader portfolios with bonds’ ability to generate income, act as a diversifier, and reduce volatility.

To accomplish this, however, investors must be nimble and seek to identify the segments that represent the most attractive trade-offs. Unlike in years past, all levers matter, including region, credit rating, and duration exposure. Astute investors have the opportunity to lean into these disparities to strike a balance between defensiveness and capturing excess returns

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