Market Reaction to Recent Fed Interest Rate Cut

Investing.com — The sharp market reaction to the Federal Reserve’s latest hawkish interest rate cut signals the beginning of a much-anticipated correction in the financial markets, according to Yardeni Research.

The market research firm notes that “there have been too many bulls with unrealistic rate-cut expectations for 2025,” which likely contributed to the volatility.

Yardeni expects this correction could extend through January, driven by uncertainties such as a potential government shutdown, a longshoremen’s strike, tariffs under a possible Trump administration, and delayed tax-related profit-taking.

Nonetheless, the firm maintains a bullish long-term outlook, forecasting a 7,000 milestone for the S&P 500 by the end of 2025.

The Federal Open Market Committee (FOMC) cut the federal funds rate by 25 basis points on Wednesday, as anticipated, lowering the target range from 4.25%-4.50%. This marks a full percentage-point reduction since the Fed began easing rates in September.

While the rate cut was widely expected, markets reacted negatively. The S&P 500 dropped nearly 3%, the NASDAQ Composite fell 3.5%, and the 10-year Treasury yield surged 13 basis points to 4.51%, the highest level since May.

The bearish sentiment was due to the hawkish tone of the Fed’s updated Summary of Economic Projections (SEP).

The dot plot, which includes nonvoting members of the committee, revealed that four participants opposed the rate cut, preferring to maintain the current policy. Among them was newly appointed Cleveland Fed President Beth Hammack, who dissented in favor of holding rates steady.

The SEP showed increasing concerns about inflation. FOMC participants raised their core Personal Consumption Expenditures Deflator (PCED) inflation forecast for 2025 by 0.3%, moving from 2.2% to 2.5%.

This revision suggests greater expectations of persistent inflation and increased uncertainty about when it will decline to the Fed’s 2.0% target, compared to projections three months ago.

The SEP also indicated a shift in the Fed’s outlook for rate cuts. The median expectation now reflects only two rate cuts in 2025, compared to four anticipated during the September meeting.

“In our opinion, given the dissent at this meeting and concern over inflation, this increases the odds of either one or even no federal funds rate (FFR) cut next year,” Yardeni noted.

Fed Chair Jerome Powell acknowledged during the press conference, saying twice, "We're significantly closer to the neutral rate."

The SEP raised the median estimate of the long-term nominal federal funds rate—the committee’s proxy for the neutral rate—from 2.9% to 3.0%.

It also maintained its forecast for long-term real GDP growth at 1.8%. But Yardeni believes economic growth will likely exceed this projection, implying that the neutral rate could be significantly higher than the Fed’s 3.0% estimate, potentially closer to 4.5%-5.0%.

“If real GDP growth beats the Fed's expectations, as we expect, then the FOMC may be on pause for a while,” the firm said.