Higher Yields, Reflation and Growth — Evening Brief – 12.19.24

There are multiple reasons to maintain a cautious near-term market view, with reflation risk perhaps top of mind – a concern that continues to grow even after the Federal Reserve decided on Wednesday to trim the federal funds rate for a third consecutive time.

While buyers came in to scoop up depressed equity shares on Thursday following the meltdown on Wednesday after the Fed’s decision, the mood remains cautious, particularly with US Treasury yields exploding higher. The US 10-year yield has rallied over the past nine trading days and currently stands at 4.59% – its highest level since May and roughly 100 basis points above the September 17 low when the Fed slashed rates by 50 basis points.

The policy-sensitive 2-year Treasury yield has significantly moved higher as well, now trading at 4.32%, nearly 80 basis points above the September 17 low and closing the gap with the Fed funds target rate for the first time in recent years. The spread between the U.S. 2-year yield and the Fed funds is currently marginally positive, indicating that the market is signaling an end to the easing cycle, at least under present conditions.

“It is a very uncertain outlook, and most of that uncertainty comes from potential changes in policy,” said Michael Gapen, chief U.S. economist for Morgan Stanley.

The circumstances seem unfavorable for the continuation of rate cuts in the face of recent indications that disinflation is stalling, and economic growth remains robust.

In terms of growth, the Commerce Department reported a 3.1% growth rate for the third estimate of U.S. GDP for the third quarter on Thursday, up from its previous estimate of 2.8%. The revised figure indicates that the third-quarter growth rate increased from the already robust 3.0% recorded in the second quarter and further suggests that the U.S. consumer remains the primary driver of economic growth.

“The strong GDP number, combined with the decline in initial jobless claims also reported on Thursday, “will dampen hopes of an immediate retracement of yesterday’s surge in bond yields (which was the largest since the 2013 Taper Tantrum),” said economist Mohamed A. El-Erian in a post on X.

Meanwhile, PCE prices for the third quarter rose 1.5%, unchanged from the second estimate. The core PCE price index, however, was revised up to 2.2% from 2.1%. The increase in the core PCE estimate highlights how stubborn inflation is, prompting the Federal Reserve to be more cautious about how much to cut interest rates next year.

It’s noteworthy that the central bank reduced its outlook for rate cuts in 2025 to two from four in its September outlook. Meanwhile, the Fed raised its inflation forecasts, projecting PCE inflation will rise 2.5% next year, up from the previous 2.1% estimate.

“Consider the FOMC’s projection for the year-end fed funds target in 2024: This outlook evolved from a starting point of 1.8% in late 2021 to a peak of 5.1% just six months ago before settling in at its 4.4%,” Bryan Jordan, Cycle Framework Insights, Inc chief strategist, shared in an email with Connect.

“This year also marks the eighth in the last 10 in which the FOMC’s fed funds outlook to start the year failed to match the actual change in policy (the lone exceptions coming when the committee correctly anticipated the 75 basis points in rate hikes in 2017 and the unchanged target rate in 2021),” he added.