More cautious Fed message stirs markets – we stay overweight US equities

The Federal Reserve (Fed) cut interest rates by 25 basis points (bps) as expected on 18 December, but also made clear that the pace of cutting will now slow going into 2025. Interest rates are now significantly less restrictive and closer to the ‘neutral’ rate that neither drives nor constrains growth, Chair Jerome Powell said.

Fed officials’ forecasts for inflation and growth were revised higher, and for unemployment slightly lower. Their ‘dot plot’ of future interest rate projections pointed to fewer cuts than in the September projections. Officials now expect two cuts of 25 bps in 2025, in line with our own forecast, with two more in 2026 and one in 2027. The Fed’s projected neutral rate was also nudged upwards again to 3%, inching closer to our own 3.5% estimate. We keep our base case for the next two cuts to take place at the March and June 2025 meetings, and an extended pause to follow thereafter at 4%.

While the 25 bps cut was widely expected, and the Fed’s predicted end-2025 rate was broadly in line with market forecasts, the market reaction was significant. Hints of more persistent risks to inflation and a slightly shallower than expected path of rate cuts ahead sent stocks and gold down and the US dollar up against a basket of currencies. Interest-rate sensitive two-year Treasury yields rose, flattening the difference between two and 10-year yields. At the time of writing, the S&P 500 has lost more than 3% from its high earlier in December and has dropped below its 50-day moving average, causing nervousness among investors.

The correction in equities was exacerbated by heavy short-term investor positioning and full valuations

In our view, the correction in equities was exacerbated by heavy short-term investor positioning and full valuations in the US market in particular. Investor concerns have temporarily focused on inflationary risks in the aftermath of the Fed decision. Some uncertainty pertaining to tariffs’ inflationary effects may still drive some temporary volatility. Yet with growth still solid going forward, we expect this to remain a short-term correction. We see upside ahead for equities in the year ahead, driven by higher earnings, and pro-growth policies from the incoming Trump administration, including tax cuts and deregulation. We retain both our global and US equity overweight positions.

We remain cautious on US Treasuries and favour Bunds and Gilts

In fixed income, we remain cautious on US Treasuries and favour Bunds and Gilts within our sovereign bond allocations, where we expect more interest rate cuts and less favourable growth dynamics in 2025. Investors concerned about US fiscal or inflation risks may consider US money market solutions, short-dated bonds, or US Treasury inflation-protected securities (TIPS). We remain positive on the dollar given ongoing outperformance of the US economy, Trump policies, and increasing policy divergence between the Fed and other major central banks. Finally, and despite a stronger US dollar, we see gold prices being supported in 2025 by ongoing investor demand for hedging geopolitical and inflation uncertainties, and from central banks diversifying their reserves.