The Fed gently eases off the brakes

The U.S. Federal Reserve cut interest rates another 25 basis points, but signaled that policy is transitioning to a new stage of slower easing.

What happened?

The Federal Reserve cut interest rates by 25 basis points (bps) as expected, taking the target range to 4.25%-4.50%. However, the details of the meeting, including the updated economic projections and Chair Powell’s press conference, leaned hawkish. We believe policy has shifted. While 2024 saw steady rate cuts totaling 100 bps, next year should be characterized by a much slower pace of cuts with more pauses and less certainty.

The Fed’s policy statement made only one substantive change, adding a reference to “the extent and timing” of additional rate cuts. The Summary of Economic Projections (SEP) included upgrades to the growth and inflation forecasts for both 2024 and 2025, relative to the last edition from September. The SEP also showed median expectations for 50 bps of rate cuts next year, notably fewer than the 100 bps penciled in previously.

In his press conference, Chair Powell hinted that policy is moving to a new phase. He said that “from this point forward, it’s appropriate to move cautiously” though “we still see ourselves as on track to continue to cut.” He said the decision to cut today was “a closer call” than at previous meetings. These comments are consistent with a slower pace of rate cuts in 2025, but not an end to the cutting cycle yet.

We continue to expect two more rate cuts next year, taking the policy rate to 3.75%-4.00%. The exact timing and magnitude will depend on the incoming inflation and labor market data, as well as policy developments. Tariffs, immigration and tax cuts may push growth and inflation off target.

Economic growth and inflation linger at elevated levels

U.S. economic growth remains strong since the last Fed meeting in November. GDP growth is running at a robust pace just below 3% annualized. Labor markets have loosened further, but by less than feared. Inflation should remain above-target next year but continues to decline slowly. Looking ahead to 2025, we expect growth to moderate somewhat more meaningfully, but remain healthy overall at around 2%.

Headline job creation rebounded in the latest monthly jobs report, showing net gains of 227,000. However, the labor force participation rate fell and unemployment ticked up, back to right around its cycle high at 4.2%. Overall, incoming data remains consistent with a further loosening in labor market conditions, which should put downward pressure on wage inflation in 2025. The risk of sharper deterioration remains present, but is not a near-term concern, with layoffs remaining low and no sign of elevated jobless claims.

The latest inflation data is more mixed. Core CPI inflation has stayed steady at 3.3% year-over-year for three consecutive months. Under the surface, shelter costs have moderated, while other core services and core goods prices have picked up. We remain more focused on housing costs than the other categories, so the latest data has strengthened our expectation that overall core inflation will moderate further in 2025.

2024 is ending on a strong footing, with growth remaining healthy, labor markets loosening but not crashing, and inflation continuing its measured improvement. We expect these themes to continue in 2025, with slightly lower growth and further progress on inflation, supporting a couple more Fed rate cuts next year.

What does this mean for investors?

Heading into 2025, our fixed income positioning is focused on four themes:

1. Current yields are near their highest levels in more than 15 years. Higher base rates have significantly enhanced income potential, with yields of about 6% or more for investment grade plus sectors such as preferred securities and securitized assets.
2. Short- and long-term rates will be higher for longer. That makes exposure to shorter-duration, floating-rate instruments such as senior loans — currently yielding 8.6% — a compelling choice, especially given their sound credit fundamentals. Like senior loans, asset-backed securities are also relatively low duration, in addition to providing attractive yields.
3. Balance duration risk with credit risk. Within investment grade categories, we are less positive on corporates, where duration is much longer than in other fixed income sectors. In contrast, preferred securities offer more incremental yield pickup. Preferreds also look well-positioned for 2025, as potential deregulation and an expected pickup in M&A (merger and acquisition) activity could bode well for banks, the largest issuer of preferreds.
4. Position for volatility. In the below-investment grade space, we favor an up-in-quality approach. Within senior loans, we find exposure to BB and B rated issues particularly attractive. BB rated loans, for example, have a healthy interest coverage ratio of 4x, according to Bloomberg.

Away from fixed income, we also see opportunities in asset classes that are more insulated from policy uncertainty. Publicly listed real assets is one such area. Companies in this part of the economy may be able to produce favorable investment results in virtually any market environment, thanks to the inherently essential functions, services or resources they provide. From real estate to commodities to infrastructure, these investments have tended to offer diversification, attractive income generation and a better hedge against inflation than other asset classes.