Shoot you down

Christmas or New Year cut?

The delayed release of the US employment report for September hit the screens this week, showing a modest bounce in job creation (119,000 versus a 4,000 reduction in August) and another small increase in the unemployment rate to 4.4%. The data is not conclusive in determining what the Federal Reserve (Fed) will decide on interest rates at its 10 December meeting. 

Market expectations of a rate cut, based on swap market pricing, at are 30%, compared to 100% in mid-October. The Fed’s November meeting minutes suggest that several officials were of the mind to keep rates unchanged for the rest of the year.

3% still expected in 2026

The modest shift in rate cut expectations has been one of timing. The magnitude remains unchanged, with the Fed Funds Rate expected to be at 3.0% by end-2026. It’s worth considering the risks to this expected rate path. 

For starters, it is not clear the current state of the US economy warrants further cuts. The Fed has a dual mandate – targeting both inflation and unemployment. Chart one encompasses that. The vertical axis plots actual inflation relative to the Fed’s core personal consumption expenditure deflator target of 2.0% (a mark above zero means inflation is higher than target). 

The horizontal axis does the same for unemployment with the Congressional Budget Office’s estimate of unemployment rate that is consistent with stable inflation (a mark below zero means unemployment is below that rate, i.e. the labour market is tight). The marks on the chart reflect where the economy was at each time the Fed has reduced interest rates since 1995.

An observation from the chart is that the Fed rarely cuts rates if the unemployment rate is increasing, and inflation is above target (stagflation). If inflation does turn out to be more persistent, this might become a real concern for markets.

Forecasts

A critical analysis of the Fed might conclude there must be a strong expectation in the Fed’s forecasts that inflation will moderate, and unemployment will rise further if it cuts rates in line with market expectations. 

In the Fed’s September Summary of Economic Projections, the central forecast was for core PCE inflation to be between 2.4% and 2.7% in 2026 (still above target) and the unemployment rate to be between 4.4% and 4.5% (slightly above the current NAIRU estimate). 

 The forecasts suggest decisions to keep on easing will be finely balanced given the existing differences of opinion at the Fed. Given that unemployment is at 4.4% already, it is likely to be the labour market that swings upcoming decisions.

Inflation bears

However, inflation is key given the observation above. I was at a conference in Europe recently where there was an overwhelming bias amongst participants that US inflation is going to rise. These expectations were based on tariffs, an expansionary fiscal policy and immigration policies sustaining higher wage growth. The same audience thought long-term US bond yields should be higher and the dollar weaker. 

By extension, the view was that the market was underestimating US inflation risks, with the inflation swaps market, for example, suggesting inflation will average just 2.5% over the next five years. If the real neutral interest rate is 1%, then a neutral Fed Funds Rate of 3.5% might be more appropriate than the 3.0% that is currently priced. 

Not a huge difference, but enough to have some impact on yields across the curve. If those conference bears are right – which I dispute - then rates will be higher on average.

Reasons to be easing

There are several arguments in support of current market pricing. First, inflation will fall meaningfully in 2026; second, the Fed will tolerate above target inflation if the labour market weakens further; third, it believes its current stance is still too tight given a weakening labour market; or fourth, political pressure (or fiscal dominance) becomes more influential on monetary policy, than strictly following the dual mandate.

Market not prepared for an extended pause

The 3% terminal rate expectation is not a slam-dunk. It will be if the US goes into recession, or the unemployment rate moves further towards 5%. Let’s see when we get more data. If the tone is weak going into the New Year, then a January cut becomes more likely which will cement expectations of three further cuts next year. That will be supportive for the US Treasury market and bonds globally. 

However, if the data doesn’t move the dial that much on where the economy is relative to the dual mandate targets, the next rate cut could get moved back out to March or April, with a tendency for yields at to move higher as a result.

Having acknowledged risk, the Fed does not meet current expectations on rate cuts in the coming months – my view is the bond market is reasonably priced today. Treasury 10-year yields have averaged between 3.5% and 4.5% over the last 40 years. Core inflation has been around 2.4% and real GDP growth around 2.5%, giving an average nominal growth rate of 5%. We are not far from any of those long-term averages. 

Cyclically, there are downside risks to growth and employment and that should guide the Fed, on balance, to take rates towards the lower end of its historical range. If that means rates fall to 3% then, almost by definition, the US economy will be closer recession than the consensus thinks today. I am inclined to think there will be no recession and rates might bottom above 3.0%, compared to the argument that there will be a recession, and rates go to 3% or below. 

Either way, there is no reason for Treasury yields to radically move out of the established trading range. A recession makes sub-4% yields more likely, but there would need to be more of an inflation shock to push them above 5%.

Performance data/data sources: LSEG Workspace DataStream, ICE Data Services, Bloomberg, AXA IM, as of 20 November 2025, unless otherwise stated). Past performance should not be seen as a guide to future returns.