Treasuries and the Fed’s Dilemma: Inflation Stabilizes, but Is the Bull Market Overstimulated?

The U.S. equity market’s recent rally has defied the odds. After a volatile Q2 2025, the S&P 500 surged 10.5%, trading at a 1% premium to fair value estimates, while non-U.S. equities outperformed by a wider margin [1]. This performance has been fueled by a mix of easing trade tensions, resilient corporate earnings, and a Federal Reserve that appears torn between its dual mandate of price stability and maximum employment. Yet beneath the surface, a troubling question lingers: Are these gains sustainable, or is the market being propped up by a Fed that risks overstimulating an economy already showing signs of resilience?

The data paints a complex picture. Inflation, as measured by the core PCE Price Index, rose to 2.9% in July 2025—the highest annual increase since February—while the core CPI hit 3.1%, a five-month high [2]. These figures remain stubbornly above the Fed’s 2% target, despite a sharp decline from the 7% peak in 2022. Meanwhile, the U.S. GDP rebounded to 3.3% annualized growth in Q2 2025, driven by consumer spending and a drop in imports, and the unemployment rate is projected to average 4.2% in 2025 [3]. This combination of inflation persistence and economic resilience has left the Fed in a bind.

The Fed’s June 2025 projections suggest a gradual path of rate cuts, with the federal funds rate expected to fall from 3.9–4.4% in 2025 to 2.9–3.6% by 2027 [4]. However, market expectations have diverged. Traders now price in a 50-50 chance of a September rate cut, down from an initial 80% probability, as robust GDP growth and low volatility reduce the urgency for easing [5]. This disconnect highlights a critical tension: The Fed is signaling caution, but the market is betting on aggressive cuts to offset a labor market that, while showing signs of softness, remains near full employment [6].

The equity market’s performance raises further concerns. The S&P 500’s gains have been driven by a mix of sectors, with growth stocks trading at an 18% premium to fair value and small-cap stocks at a 17% discount [1]. This divergence suggests uneven fundamentals, where speculative bets on AI-driven growth and rate-sensitive sectors (like housing and utilities) have outperformed more cyclical industries. The wealth effect from rising equities—particularly in a low-interest-rate environment—risks masking underlying inflationary pressures. For instance, the core PCE’s 2.9% annual increase reflects persistent pricing in services, a sector less responsive to monetary policy [2].

The Fed’s dilemma is further complicated by the interplay between monetary policy and fiscal stimulus. Tariff-induced price increases, while contributing to inflation, have also created uncertainty in durable goods spending [7]. This duality forces the Fed to balance the need to cool inflation with the risk of stifling economic growth. The July 2025 FOMC minutes underscored this tension, noting that “inflation persistence with a softer labor market” was a key concern, though most participants viewed inflation as the greater risk [8].

For investors, the key question is whether the current bull market is being overstimulated by the expectation of rate cuts rather than by organic economic strength. The Fed’s projected 2 percentage points of cuts through 2027, bringing the target rate to 2.25–2.50%, could further inflate asset prices, particularly in sectors sensitive to interest rates [9]. However, if inflation proves more persistent than anticipated, the Fed may be forced to delay cuts, creating volatility for markets that have priced in aggressive easing.

The risk of overstimulation is not abstract. The S&P 500’s 10.5% Q2 gain occurred against a backdrop of a 3.3% GDP expansion and a 4.2% unemployment rate, suggesting that the market is pricing in a soft landing scenario that may not materialize [3]. If inflation remains above 2% into 2026, as the Fed’s own projections suggest, the case for rate cuts could weaken, leading to a reassessment of equity valuations.

In the end, the Fed’s dilemma mirrors the market’s: How to navigate a fragile equilibrium between inflation control and economic growth. For now, the market appears to be betting on a continuation of the Fed’s accommodative stance, but history shows that such bets can unravel quickly when data diverges from expectations. Investors would be wise to monitor the interplay between inflation, employment, and Fed policy, recognizing that the current bull market may be as much a product of monetary alchemy as it is of economic fundamentals.

Source:
[1] Morningstar's Q3 2025 US Market Outlook [https://www.morningstar.com/markets/morningstars-q3-2025-us-market-outlook-has-storm-passed-or-are-we-eye-hurricane]
[2] Personal Consumption Expenditures Price Index [https://www.bea.gov/data/personal-consumption-expenditures-price-index]
[3] Third Quarter 2025 Survey of Professional Forecasters [https://www.philadelphiafed.org/surveys-and-data/real-time-data-research/spf-q3-2025]
[4] The Fed - June 18, 2025: FOMC Projections materials [https://www.federalreserve.gov/monetarypolicy/fomcprojtabl20250618.htm]
[5] Fed Rate Cut? Not So Fast [https://www.morganstanley.com/insights/articles/fed-rate-cut-september-2025-forecast]
[6] Federal Reserve's Powell balances inflation, labor market risks [https://www.usbank.com/investing/financial-perspectives/market-news/federal-reserve-interest-rate.html]
[7] Rising inflation, increased spending complicate Fed's next decision [https://realeconomy.rsmus.com/rising-inflation-increased-spending-complicate-feds-next-decision/]
[8] Federal Reserve's July 2025 meeting minutes [https://www.usbank.com/investing/financial-perspectives/market-news/federal-reserve-interest-rate.html]
[9] How Much Will the Fed Cut Interest Rates? [https://www.morningstar.com/markets/when-will-fed-start-cutting-interest-rates]