Fed's Last Dance of 2023: Markets Brace for Potentially Hawkish Rate Cut

With the Federal Reserve's final interest rate decision of the year set to be announced this week, markets are abuzz with anticipation. A 25-basis point rate cut is highly anticipated by market participants, which, if realized, would bring the target range for the federal funds rate down to 4.25%-4.50%. The decision reflects the Fed's increasingly data-dependent policy approach, with investors poised to scrutinize Chairman Jerome Powell's post-meeting commentary and the Summary of Economic Projections, especially the dot plot, for clues on the future rate path into 2025 and beyond.

The market's expectation for a rate cut appears predicated on several factors. The softening labor market is evident with November's unemployment rate ticking up to 4.2% alongside a declining labor participation rate. Additionally, a slowdown in housing inflation—despite the broader inflationary pressures—could bolster the rationale for further easing to prevent undue labor market stress.

However, even as the December rate cut is nearly fully priced in, attention will be on the potential for a "hawkish cut," where despite policy easing, caution is signaled about the pace of future cuts through the dot plot or Powell’s conference remarks. Discussions are also rising about a potential pause in the Fed's cutting cycle in 2025, should stubborn inflation or resilient economic data prompt a re-evaluation of current easing trajectories.

Market participants are increasingly considering that the Fed might decrease the number of projected rate cuts in 2025 due to persistent inflation risks, economic resilience, and potential inflationary pressures arising from policies by the newly elected administration, potentially impacting trade. The dot plot covering projections for 2025, 2026, and 2027 will be crucial in shaping market sentiment, as these will offer insights into the Fed's approach towards rate adjustments long term.

Against a backdrop of robust recent data, some analysts argue that the Fed's room for maneuver on rate cuts in the upcoming year may not exceed 50 basis points. This anticipation sharply contrasts with the Fed's September projections, which pointed towards a 100-basis point reduction. Meanwhile, the Federal funds futures market echoes this sentiment, showing a decline in expectations for substantial reductions in the months ahead, as seen in declining open interest for January and February futures.

The evolving trajectory of U.S. Treasury yields further mirrors these dynamics. Recent trading sessions have seen yield increases across maturities, with gains observed in 2-year, 5-year, 10-year, and 30-year Treasuries. As investors recalibrate their positions ahead of critical economic data, they maintain a keen focus on inflation metrics like the CPI for insights that could sway the Fed's near-term policy decisions.

This heightened focus culminates in expectations around forthcoming CPI data, which will offer pivotal insights into inflation dynamics as the Fed prepares for a significant deciding moment in its December policy meeting. Steadfast inflation trends could dampen the probability of rate cuts, injecting fresh complexity into the market's navigation of monetary policy outlooks. Investors eagerly await these developments, aware of their potential to sway financial markets and economic forecasts alike.