The Fed's TACO Trade: Is Now the Time to Double Down on Duration?

The Federal Reserve's June 2025 decision to hold rates steady at 4.25%-4.50% has reignited debates about the credibility of market expectations for policy easing. While traders have priced in just one rate cut by year-end, Fed Chair Jerome Powell hinted at two reductions, with further easing likely in 2026. This divergence creates a compelling opportunity: investors who bet on the Fed's more dovish path could profit from mispriced rates markets. The catalyst? The "TACO trade"—a phenomenon where markets rebound after U.S. President Donald Trump's tariff threats fizzle—has conditioned investors to underweight risks, even as the Fed's balance sheet and labor market resilience suggest deeper cuts are coming.

The TACO Trade: A Catalyst for Mispricing

The TACO trade (Trump Always Chickens Out) has become a self-fulfilling prophecy, with markets rallying each time Trump's tariff threats fail to materialize. Recent examples include the June 2025 delay on 50% European tariffs and scaled-back Chinese levies, which sparked a 2% surge in the S&P 500. This dynamic has lulled investors into complacency, anchoring expectations around fewer rate cuts than the Fed's own projections.

But this optimism may be misplaced. The Fed's June statement removed progress toward its 2% inflation target, signaling heightened concerns about persistent price pressures. Yet Powell emphasized the “highly uncertain” environment, citing tariff impacts and fiscal risks. This ambiguity creates room for the Fed to cut rates more aggressively than markets anticipate, particularly if inflation moderates faster than expected.

Labor Market Resilience: A Double-Edged Sword

The U.S. labor market remains a pillar of strength, with unemployment at 4.4% and job openings exceeding workers. This has allowed the Fed to maintain a hawkish veneer while preparing for easing. Historically, the Fed has cut rates preemptively when labor markets soften—a pattern seen in 2001 and 2008.

Critically, the Fed's June forecast assumes two rate cuts by year-end, with further reductions in 2026. If labor markets remain resilient, the Fed may feel empowered to cut deeper without reigniting inflation—a scenario markets have yet to price.

Historical Precedents: The Fed's Track Record of Aggressive Easing

The Fed's history reveals a pattern of overcompensating in downturns. During the 2001 recession, the Fed slashed rates by 475 basis points to 1.75%, while in 2008, it drove rates to zero. Both moves outpaced initial market expectations.

Today's parallels are striking. The Fed's June projections imply a terminal rate of 2.25%-2.50% by 2027—100 basis points below market expectations. If the Fed follows its own playbook, long-duration assets like 30-year Treasuries (which have priced in minimal cuts) stand to gain.

The Case for Duration: Playing the Mispricing

The yield curve reflects this mispricing. The 10-year Treasury yield trades at 3.7%, while the Fed's projections imply it could fall to 3.25% by 2028. For every 25 basis point drop in yields, a long bond fund's price rises by roughly 2%.

Investors should consider adding duration via instruments like the iShares 20+ Year Treasury Bond ETF (TLT). Meanwhile, the Fed's focus on secular trends—aging demographics and slower productivity—suggests a prolonged era of low rates, favoring long-dated bonds.

Equity Opportunities: Dividends Over Speculation

Equities are less straightforward. The S&P 500's P/E multiple has expanded to 22x, a “4-sigma event” driven by TACO-driven optimism. Yet sectors insulated from tariffs—such as utilities, healthcare, and consumer staples—are undervalued.

Dividend-focused equities offer stability. The ProShares S&P 500 Dividend Aristocrats ETF (NOBL) yields 2.5%—attractive relative to bonds—and benefits from Fed easing.

Risks and Cautions

The TACO trade's end could upend this thesis. If Trump's tariff threats escalate, or inflation proves sticky, the Fed may delay cuts. Additionally, China's fragile housing market and Japan's export struggles could weigh on global growth.

Conclusion: Position for the Fed's Hand

The Fed's TACO trade has lulled markets into underestimating the likelihood of aggressive easing. Investors should exploit this mispricing by:
1. Buying duration: Treasuries offer asymmetric upside if the Fed cuts more than expected.
2. Favoring dividends: Stable, cash-rich companies will outperform in volatile markets.
3. Avoiding rate-sensitive sectors: Tech and cyclicals face headwinds if inflation resurges.

History shows that the Fed's easing cycles reward patience. Now is the time to double down on duration—and let the TACO trade's next chapter unfold.