U.S. Rates: How Low Can They Go?
Daniel FosterA more dovish rate cut than anticipated by the U.S. Federal Reserve has created an interesting setup for fixed income markets next year. The focus on its independence adds another dimension.
A more dovish rate cut than anticipated by the U.S. Federal Reserve has created an interesting setup for fixed income markets next year. The focus on its independence adds another dimension.
As expected, the Federal Reserve cut interest rates last week for the third consecutive time this year, lowering the policy rate by a quarter point to the 3.5 – 3.75% range, the lowest level in three years.
Mounting concerns over a weakening U.S. labor market, outweighing sticky inflation, persuaded the Fed to cut again, with risk markets overall reading a more dovish tone than expected from the meeting, broadly supporting equity indices and helping push front-end Treasury yields lower.
Importantly, Fed Chair Jerome Powell suggested the Fed had now done enough to bolster the threat to employment while leaving rates high enough to continue weighing on price pressures, a framing that could otherwise be read as the Fed is comfortable pausing at this level and waiting to see how the economy performs.
While the majority of the 12 voting Federal Open Market Committee (FOMC) members voted for the cut, three dissented Fed governor Stephen Miran, who called for a half-point reduction, and Chicago Fed's Austan Goolsbee and Kansas City Fed's Jeffrey Schmid, who both backed a hold.
Dissent was expected, and even though the numbers were lower than some estimates, it still marked the biggest dispersion among FOMC members since 2019.
Hawks vs. Doves
So long as there is tension between the balance of risks across the Fed's dual mandate, we expect the divergence in opinion among members on future policy direction will continue.
Interestingly, the FOMC created some optionality on future decisions, stating that in "considering the extent and timing of additional adjustments to the target range for the federal funds rate, the Committee will carefully assess incoming data, the evolving outlook, and the balance of risks."
That assessment will come into play this week as a series of important delayed macro data is released—including the October and November payrolls and unemployment rate for November—potentially giving some indication as to which way the Fed may lean going into next year.
Chair Powell posited that the current level of short-term rates is now "within a broad range of estimates of its neutral value" and argued that any further rate cuts from here would need to come from a combination of materially weaker labor market with a higher unemployment rate.
Whether, and to what extent, we see that, our current baseline expectation is that the FOMC does deliver another quarter-point reduction in the first quarter of 2026, with more cuts potentially through the year should downward pressure be applied by a new dovish FOMC chair.
Powell steps down in May, with Kevin Hassett, President Trump's economic adviser and known dove, seen as the favorite to succeed him although other candidates, including former Fed governor Kevin Warsh, Fed governors Christopher Waller and Michelle Bowman, and BlackRock's Rick Rieder, are also on the shortlist being vetted by Treasury Secretary Scott Bessent. An announcement is expected early in the new year, an event that will likely have read-through across the rates market.
Market Impact
Post the Fed meeting, front-end Treasury yields have followed policy rates lower—a move partly supported by the central bank announcing it would immediately start buying short-dated Treasury bills to help manage market liquidity—yet long-end yields across 10- and 30-year Treasuries have broadly risen.
Higher expected growth rates combined with increasing concerns about fiscal overreach and debt sustainability are among the main factors driving long-end yields higher. Such factors are, therefore, priced in, which in our view suggests the worst may be over for long interest rates, a call we highlighted in our fixed income theme for Solving 2026. Indeed, we would argue that improving carry profiles in longer maturities on the back of lower policy rates should provide support to the long end of yield curves.
