Anticipating the Fed's December Rate Decision: Implications for Equity and Bond Markets

The Federal Reserve's December 2025 meeting looms as a pivotal moment for markets, with investors bracing for a potential rate cut amid a backdrop of stubborn inflation and mixed economic signals. The Fed's preferred inflation gauge, the core Personal Consumption Expenditures (PCE) price index, has shown a modest cooling trend but remains above the central bank's 2% target. As the market digests the latest data and positions itself for the Fed's next move, the interplay between inflation dynamics and investor sentiment will shape the trajectory of both equity and bond markets.

The PCE Picture: A Gradual, Uneven Disinflation

The September 2025 core PCE price index rose 0.2% monthly, settling at an annual rate of 2.8%-a slight moderation from August's 2.9% but still well above the Fed's target. The October data, released on December 5, confirmed a similar trajectory, with core PCE inching up 0.2% monthly, maintaining the annual rate at 2.8%. While this suggests a gradual disinflation, the persistence of high services inflation-particularly in housing and healthcare-remains a drag. As stated by the Cleveland Fed's nowcasting model, core PCE is projected to trend downward through mid-2026 but won't reach 2% until the latter half of the year.

The headline PCE, which includes volatile food and energy prices, also rose 0.3% monthly in October, aligning with expectations of a mid-2% annual rate. Goods prices have eased, but energy costs remain stable, creating a mixed picture for the Fed. The delayed release of October data due to the government shutdown has further muddied the waters, leaving policymakers with limited near-term indicators to guide their decision.

Bond Market Positioning: Yields Dip as Rate Cuts Loom

With the Fed's easing cycle in view, Treasury yields have retreated. The 10-year yield, a key benchmark for long-term borrowing costs, has fallen as investors price in a 25-basis-point rate cut in December and additional cuts in early 2026. The yield curve has steepened compared to recent years, reflecting expectations of prolonged Fed easing and a stable inflation outlook. However, long-term yields remain anchored by broader economic trends, including supply-side constraints and the lingering effects of the pandemic-driven labor market shifts.

The bond market's optimism is tempered by the Fed's internal divide. Hawks, led by figures like John Williams, have emphasized the need for caution, while doves argue that inflation is on a clear downward path. This schism has amplified volatility in the bond market, as reflected in elevated levels of the VIX and ICE MOVE Index.

Equity Market Dynamics: Sectors Split as Tech Stumbles

Equity markets have shown a mixed response to the inflation backdrop. The S&P 500 posted modest gains in November 2025, but the information technology sector, particularly AI-focused companies, has underperformed. Investors are growing skeptical about the ability of tech firms to monetize their AI investments, leading to profit-taking and a shift toward defensive plays.

Defensive sectors like healthcare and utilities have outperformed, reflecting a risk-off sentiment as investors hedge against potential volatility around the Fed's decision. The energy sector, meanwhile, has benefited from stable oil prices and expectations of a slower-than-anticipated rate cut cycle.

The Fed's Dilemma: Balancing Act Between Inflation and Growth

The Fed faces a classic dilemma: cutting rates too aggressively risks reigniting inflation, while delaying cuts could stifle economic growth. The October PCE data, while showing progress, underscores the uneven nature of disinflation. Services inflation, particularly in housing and healthcare, remains stubborn, driven by wage pressures and structural bottlenecks.

Market expectations for a December rate cut now stand at 87.2%, according to the CME FedWatch tool, but this could shift if the October PCE report reveals hotter-than-expected inflation. A "higher-for-longer" scenario remains on the table if services inflation persists, which would prolong the current yield curve steepening and weigh on growth-sensitive sectors.

What's the Takeaway for Investors?

For investors, the December meeting is a critical inflection point. Here's how to position your portfolio:
1. Bonds: Stick with a barbell strategy-hold short-term Treasuries to benefit from near-term rate cuts while maintaining exposure to long-term bonds if inflation surprises to the downside.
2. Equities: Favor sectors with pricing power and resilient demand, such as healthcare and utilities. Avoid overleveraged tech stocks unless AI monetization becomes clearer.
3. Cash: Maintain a cash buffer to capitalize on potential volatility around the Fed's decision and the October PCE release.

The Fed's December move will likely be a 25-basis-point cut, but the path beyond that remains uncertain. As always, the key is to stay nimble and let the data-particularly the PCE report-dictate your next steps.