Shifting Fed Policy Expectations: A Policy Pivot and Its Market Implications

The Federal Reserve's evolving policy trajectory in late 2025 has sparked significant market recalibration, particularly as the likelihood of a January 2026 rate cut has diminished. According to CME FedWatch data, the probability of a 25-basis-point cut in January 2026 stood at 17.7% as of December 28, 2025, with the likelihood of no change remaining high at 82.3%. This marks a notable shift from earlier November 2025 assessments, which pegged the chance of a January cut at just 3.9%. Meanwhile, expectations for a March 2026 cut have risen to 45.6%, suggesting a delayed but not abandoned easing cycle. These developments signal a potential policy pivot toward greater caution, with profound implications for fixed-income and equity markets.

Fixed-Income Markets: Yields Rise Amid Uncertainty

The Fed's apparent pivot has directly influenced bond yields. A December 2025 rate cut of 25 basis points, bringing the federal funds rate to 3.50%-3.75%, was accompanied by a hawkish revision of future easing expectations. Long-end Treasury yields surged, with the 30-year yield climbing to 4.85%, reflecting reduced confidence in aggressive rate cuts and persistent inflation concerns. The Fed's revised dot plot, projecting only one additional 2026 rate cut, further underscored this caution.

This tightening of yield expectations contrasts with earlier optimism. In November 2025, the market had priced in a 3.9% chance of a January cut, but shifting labor market data-including a rising unemployment rate and weaker wage growth-prompted investors to reassess the Fed's timeline. Higher yields now reflect a recalibration of risk premiums, as investors factor in the possibility of prolonged higher rates and a slower path to normalization.

Equity Markets: Resilience Amid Divergent Signals

Equity markets have responded to the Fed's pivot with a mix of resilience and caution. The S&P 500 closed 2025 with an 18% gain, supported by accommodative monetary policy. However, the December 2025 FOMC meeting, marked by a 9-3 vote split, highlighted internal divisions within the Fed, with dissenters advocating for either a larger cut or no change at all. This uncertainty has led to sectoral shifts, with cyclical and value stocks outperforming in global markets, particularly in Europe and Asia.

The equity market's focus on AI-driven growth sectors has persisted, though scrutiny over profit sustainability has intensified. Analysts note that while lower rates typically support valuations, the Fed's delayed easing has raised recession risks, tempering enthusiasm. Morgan Stanley's December 2025 equity outlook emphasized that "the AI cycle remains a central narrative," but warned of potential headwinds from sticky inflation and geopolitical tensions.

Broader Implications and Forward-Looking Considerations

The Fed's balance sheet operations also play a critical role. The reinvestment of maturing Treasuries and MBS into shorter-term assets has kept banking system reserves ample, indirectly supporting liquidity. However, narrowing yield differentials between U.S. and international bonds may redirect capital flows, altering global market dynamics.

Looking ahead, investors must navigate a delicate balance. While the Fed's dovish trajectory in 2025 has created a supportive backdrop for equities, the December 2025 pivot signals a more data-dependent approach. Persistent inflation near 3% and the selection of a new Fed chair in mid-2026 add layers of uncertainty. For fixed-income investors, shorter-duration assets and sectors like real estate and small-cap equities appear increasingly attractive.

Conclusion

The Fed's shifting policy expectations, particularly the rising odds of no January 2026 rate cut, reflect a recalibration toward caution. This pivot has directly impacted bond yields and equity sector rotations, underscoring the market's sensitivity to central bank signals. As 2026 unfolds, the interplay between inflation, labor market data, and geopolitical risks will remain pivotal. Investors must remain agile, balancing optimism about AI-driven growth with prudence in the face of potential policy delays and macroeconomic headwinds.