Fed’s change in tone spooks the market

This week, the Federal Reserve reduced its benchmark interest rate by 0.25 percentage points to a range of 4.25%–4.5%, marking the third cut this year. Notably, the Fed signaled a more gradual approach to easing in 2025, projecting only two rate cuts instead of the previously anticipated four due to persistent inflation concerns. The 10-year Treasury yield climbed to 4.59% in response, its highest level in six months. The S&P 500 and Nasdaq Composite experienced significant declines, falling by 3% and 3.6%, respectively.

• The market was spooked by the significant dissent, with four Fed officials voting not to cut rates, as well as the outlook for two more cuts in 2025 instead of four
• Jay Powell’s press conference was considered “hawkish,” as he expressed the need to see inflation start coming back down again to warrant more rate cuts
• The stock market’s selloff accelerated as the press conference went on, as the market adjusted to yet another new Fed regime
• The 10-year treasury trading to almost its high of the year was more notable in our view, as this is the benchmark for most lending rates
• The Fed finds itself in a tight spot yet again, as inflation has been stubborn, and there is the added uncertainty of the impact of Trump’s second term

10-yr treasury yields surge

As noted above, the 10-year Treasury yield climbed significantly, nearing its highest level of the year. Investors reacted to the Federal Reserve's cautious tone, which signaled a slower pace of rate cuts in 2025 amid persistent inflation concerns. The rise in yields reflects growing apprehension over sustained higher borrowing costs, fiscal deficits, and uncertainty surrounding the Fed's next steps. This price action highlights the ongoing volatility in bond markets as investors adjust to a higher-for-longer rate environment.

• Since the Fed began cutting interest rates in September, the yield on the 10-yr treasury has gone up almost 100bps (1%)
• This is the opposite direction of the 100 bps of cuts of the overnight Federal Funds rate
• As we have written about before, the Fed does not control the long end of the bond market (including the 10yr treasury)
• However, this is what most financial institutions use to price interest rates for consumers (mortgages, credit cards) and corporations
• While the Fed has been lowering interest rates, the interest rates most experience have actually gone higher
• This is due to higher-than-expected inflation, fiscal deficits, and more recently, the uncertainty around Trump’s second term
• If the 10-yr continues to climb higher, it will likely become a headwind for stock prices

Market rally has been unhealthy

While the stock market (as defined by the S&P 500) has been making new all-time highs all year, the rise has been less healthy if you look underneath the surface. The so-called Mag 7 continued to drive overall index performance most of the year, with the market performance only beginning to broaden out in the late summer. More recently, in December, as the S&P 500 was making new highs, the equal-weighted S&P 500 was down almost 4% for the month. This was before the Fed meeting took the overall index down almost 4%.

• The stock market’s negative reaction on Dec 18th showed that the underlying rally was not as healthy as it might seem
• Most stocks were actually lower on the month with gains being held by a handful of the large cap tech companies
• Technicals were also poor as indicators such as advance/decline ratios and stocks trading above their 200 day moving average showed unhealthy internals
• The Dow Jones Industrial Average, which is comprised of only 30 stocks and has a different tech sector exposure than the S&P, declined for 10 straight sessions, something that it has not done in 50 years
• The violent nature of the selloff and the spike in volatility showed how fragile this rally has really been

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