Why market expectations of the US Fed’s rate path may be wrong
Softening wage growth and cooling housing costs will allow inflation to moderate further, giving the central bank room to continue cutting rates
THE recent rise in 10-year US Treasury yields in January, shortly after the US Federal Reserve cut rates in December, has sparked widespread discussion.
Traditionally, rate cuts by the Fed tend to pull long-term yields lower, but this time they have climbed instead, reaching 4.8 per cent before President Donald Trump’s inauguration. How should we interpret this unusual divergence, and what does it tell us about the path of interest rates and inflation going forward?
The current environment mirrors the reverse of what Alan Greenspan famously called the “bond conundrum” in the early 2000s. Back then, despite an aggressive tightening campaign by the Fed that saw policy rates increase by 400 basis points, long-term rates remained remarkably stable, causing a sharp flattening of the yield curve.
Today, the situation has flipped. The Fed funds rate is on a downward trajectory, yet long-term yields are stubbornly high. This divergence highlights structural changes in the market, such as growing fiscal deficits, increased government borrowing, and the rebuilding of the term premium. These forces have kept long rates elevated and suggest that we may not see a dramatic drop in yields, even if the Fed continues its cutting cycle.
A case for further rate cuts
Although the market is pricing in a more hawkish policy from the Fed, reflecting concerns that Trump’s policies might reignite inflation, we believe softening wage growth and cooling housing costs will allow inflation to moderate further, giving the Fed room to continue cutting rates.
The labour market, while still tight, is gradually rebalancing. Wage pressures, which have been a persistent driver of inflation, are easing. Data from the US Bureau of Labor Statistics indicates that the year-on-year increase in average hourly wages has fallen from nearly 6 per cent in 2022 to just 3.9 per cent in December of last year – a trend we expect to continue. As wages moderate, inflationary pressures on services – a category heavily influenced by labour costs – should abate.
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Meanwhile, housing costs, another significant component of inflation, are showing signs of cooling. The Owners’ Equivalent Rent (OER), a measure of the amount homeowners would pay or earn from renting their property, has started to reflect the broader declines observed in private-sector rent measures.
In November 2024, OER rose 0.2 per cent, the smallest gain since April 2021, following a 0.4 per cent increase in October. This signals a meaningful slowdown in housing inflation and provides further evidence that inflation is headed lower.
However, some factors could complicate this outlook. Tariffs, for instance, can temporarily push up prices, but they don’t contribute to sustained inflation. Unlike wage growth, which has a persistent effect on costs, tariffs represent a one-time shift in price levels. Moreover, many of the tariffs introduced under the Trump administration are intended as negotiating tools rather than permanent policies, limiting their long-term inflationary impact.
Immigration policy is another area to watch. While there’s ongoing political rhetoric around curbing immigration, sweeping mass deportations seem unlikely, as the US economy relies heavily on immigrant labour. Expelling large numbers of undocumented workers or drastically restricting immigration could exacerbate labour shortages, push up wages, and reignite inflationary pressures.
Instead, we believe it’s more probable that the Trump administration will launch targeted policies, allowing the labour market to adjust without significant disruption.
Fixed income reclaims its rightful place
Looking ahead, we anticipate the Fed will cut rates further, perhaps as early as the Federal Open Market Committee meeting in March. While larger corporations with access to capital markets have navigated the high-rate environment relatively well, small businesses reliant on commercial bank loans are feeling the squeeze of double-digit borrowing costs.
This situation is unsustainable and could weigh on economic growth unless rates come down. Over time, even larger firms will face higher refinancing costs, reinforcing the need for a lower cost of capital.
If interest rates do fall, we expect yield curves to remain steep and long-term rates relatively high. This creates a favourable environment for fixed income, in which bonds can once again offer the income, carry, and defensive characteristics investors were accustomed to before the crisis years – a welcome shift for long-term investors. US mortgage-backed securities stand out as particularly compelling, offering better yields than corporate bonds with less risk.
Globally, policy divergence among central banks is creating pockets of opportunity. Japan, for instance, is moving in the opposite direction of the Fed and the European Central Bank by raising rates in response to ongoing wage pressures. This divergence makes Japan’s bond market especially appealing.
Investors seeking to navigate this environment might consider a short-duration strategy in Japan while favouring longer-duration bonds in other markets to capture potential upside.
The UK market also presents an interesting opportunity for investors. Gilt yields have risen amid concerns about sticky inflation, fiscal challenges, and weak growth, which are likely to pressure the Bank of England into cutting rates more aggressively than the market currently expects. This could benefit gilts in 2025.
A flexible approach amid volatility
As for the US, the narrative of exceptionalism – one of prolonged outperformance – may face challenges. Much of the gains have already been realised. For instance, the US dollar is at its strongest in years; US interest rates are priced for no further cuts; and the AI boom has inflated equity market valuations.
Against this backdrop, we believe bonds are regaining their traditional role as a source of steady income. The current environment is well suited for long-term fixed-income investors, particularly those looking to diversify globally. While bonds may not deliver the outsized gains of past equity bull markets, their relative stability and attractive yields make them a cornerstone for a balanced portfolio.
For investors not eager to make these decisions themselves, flexible funds targeting total and absolute return or income can take advantage of both attractive opportunities and defensive strategies. Combined with their ability to navigate ongoing uncertainties, these strategies may prove an attractive option for cash currently sitting on the sidelines.
The writer is head of global fixed income, BNP Paribas Asset Management
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