Equities and bonds fall on hawkish Fed and government shutdown fears

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What happened?

US stocks and bonds fell in tandem on Wednesday. This followed the Federal Reserve cutting rates as expected, yet its economic forecasts and Fed Chair Powell's hawkish commentary all pointed to fewer US rate cuts in 2025.

The Fed cut the effective range for the fed funds rate by a further 25bps to 4.25-4.5%, its third reduction since September, bringing cumulative cuts to 100bps. However, the median dot plot—policymakers’ projections for future rate cuts—pointed to just two further 25bps cuts in 2025, down from four cuts in September when the projections were last published and below the 75bps of cuts expected by investors. The median dot for long-term interest rates also climbed to 3%.

In its statement the Fed noted that “economic activity has continued to expand at a solid pace” while the unemployment rate “remains low” and inflation “remains somewhat elevated.” Notably, the Fed now sees PCE inflation at 2.5% at the end of 2025, compared with 2.1% in its September forecasts.

In the press conference after the meeting, Fed Chair Jerome Powell said that some officials had identified policy uncertainty arising from the new Trump administration as a reason for a more cautious approach. Powell compared the situation to when “driving on a foggy night... you slow down.” However, Powell emphasized that the main reason for the more cautious outlook is that progress on inflation, yet again, had underperformed relative to expectations.

Rising fears of a US government shutdown also contributed to the sell-off. President-elect Trump and Vice President-elect Vance voiced their opposition to a continuing resolution proposal negotiated between House Speaker Johnson and the Democrats, which would fund the government until next March. Trump's preference for “a streamlined spending bill” and for Republicans to lobby for an increase in the debt ceiling in the last days of the Biden administration led to heightened investor concerns about a government shutdown by the end of this week. One major prediction market priced the likelihood of a government shutdown before year-end at around 50%, from roughly 10% the day before.

The S&P 500 responded with a 2.95% decline to 5,872—the sharpest post-Fed-meeting fall in more than 20 years. The yield on 10-year US Treasuries rose by 11bps to 4.5%. Futures markets moved to price in fewer rate cuts, with just 36bps of additional easing now expected by the end of next year.

At the time of writing, Asian and European equity indexes followed US markets lower, posting declines of around 1%. The 10-year US Treasury yield stood at 4.52%, the highest level since May, while the US dollar index hovered near two-year highs and the VIX Index of implied US equity volatility steadied at 21, below the 27.7 level, immediately after the Fed decision but still above its long-run average.

What do we expect?

The move higher in the Fed’s dot plot is logical since growth has been stronger, unemployment is lower than expected, and inflation is running higher than the Fed anticipated in its September summary of economic projections.

Chair Powell also noted that policy rates were now closer to the neutral rate, at which policy neither boosts nor slows the economy. The closer the Fed is to the neutral policy rate, the harder it becomes to justify further cuts. The Fed’s estimate of neutral has been creeping up over time and is now seen at 3% in the longer run. If the economy continues to grow rapidly, with inflation above the Fed’s 2% target, it would suggest that rates may have to stay higher than the 3% long-run level in the near term, in order to balance the economy.

There is a risk that the Fed does not cut in March: If the inflation data come in hotter or there is unexpected fiscal stimulus (e.g., Trump administration stimulus through reconciliation), the Fed could hold off on a March cut. If the Fed were to forego a cut in March, it would be challenging to get 100bps of cuts for the year.

We believe the Fed remains data-dependent, and future economic indicators will continue to play a significant role in shaping the US central bank’s next steps. The Fed’s preferred gauge of inflation, the personal consumption expenditures (PCE) price index, is due tomorrow, and we expect overall inflation to moderate further in the months ahead. Jobs data will also remain an important consideration as the Fed continues to assess the health of the labor market.

How do we invest?

Overall, we believe investors should anticipate a deceleration in the pace of rate cuts in 2025 and near-term volatility as markets recalibrate the Fed’s standpoint. But, while the pace of rate cuts may now be slower than expected, with the Fed reiterating that policy remains restrictive, the direction of travel remains clear.

A mixture of resilient US activity, lower borrowing costs, a broadening of US earnings growth, further AI monetization, and the potential for greater capital market activity under a second Trump administration create a favorable backdrop for US equities, in our view. We expect the S&P 500 to hit 6,600 by the end of next year and see scope for underallocated investors to use any near-term turbulence to add to US stocks, including through structured strategies with capital preservation features to take advantage of the rise in yields, or through yield-generating strategies that seek to buy equities on dips.

Investors should also deploy excess cash into high-quality and diversified fixed income strategies, select equity income strategies, and structured investment approaches. These can offer income generation and portfolio diversification, as lower interest rates will likely erode returns on cash next year.

Gold can still play a diversifying role in portfolios, especially if US political uncertainty intensifies. While higher interest rates and yields would potentially be headwinds to the precious metal, we believe other demand factors like central bank buying, de-dollarization trends, and investor ETF interest can underpin prices.

We also see merit in diversifying with alternative investments, including hedge funds and private markets. For example, equity market neutral hedge funds stand 10.2% higher year-to-date, on course for the best annual performance since 2000 (based on HFRI EH: Equity Market Neutral Index data). We like this strategy, as it would be well-placed if US political uncertainty and investor reassessment of the Fed's path were to drive sharp rotations between sectors, factors, and stocks in 2025. Investing in alternative assets comes with unique risks, including, but not limited to, illiquidity.