By Gertrude Chavez-Dreyfuss

NEW YORK (Reuters) – Bond investors are anticipating a quarter-point interest rate cut by the Federal Reserve on Wednesday. However, they expect the central bank to slow down its easing in 2025 due to rising inflation concerns under the Trump administration.

Market participants are avoiding long-dated Treasuries as U.S. inflation appears more persistent, opting instead for shorter maturities, notably two to five-year notes. Expectations of higher inflation often lead to a selloff in long-term bonds, causing yields to rise as investors seek compensation for added risk.

The Fed is anticipated to lower its benchmark overnight rate by 25 basis points to a target range of 4.25%-4.50% during a two-day policy meeting starting Tuesday. However, future intentions remain uncertain.

BNP Paribas forecasts the Fed will maintain steady rates throughout next year and only resume cuts in mid-2026. In contrast, other institutions predict two or three additional quarter-point reductions in borrowing costs.

"A hawkish cut is consistent with what the data might indicate and potential policy changes from the new administration," said George Bory from Allspring Global Investments. He pointed out that the Fed is preparing the market for a slower pace of rate cuts, enhancing its ability to respond to future data and policy shifts.

Recent economic data shows a resilient U.S. economy, with job creation continuing and inflation remaining elevated. Core consumer prices rose 0.3% for the fourth month in November, indicating that progress towards the Fed's 2% inflation target is stalling.

Investors are closely watching the Fed’s quarterly economic projections, including rate forecasts, which reflect expected easing. In September, the dots indicated a policy rate of 3.4% by the end of 2025.

Between March 2022 and July 2023, the Fed hiked rates by 5.25 percentage points to combat rising inflation, which puts the target policy rate between 5.25% and 5.50%.

"The Fed's summary of economic projections will be less dovish than it was in September, reflecting stronger economic commentary from Fed Chair Jerome Powell," said Greg Wilensky from Janus Henderson Investors. He expects a 25 basis point increase in the 2025 dots and noted that bond portfolios are now biased towards shorter maturities.

Investors had been purchasing longer-dated assets throughout the year in anticipation of the Fed's easing and a potential recession. As rates decrease, higher-yielding bonds become more appealing, raising their prices. Maturities of five to 10 years provide price gains when rates drop but carry less risk than longer bonds.

Recently, some investors have shortened their duration, preferring shorter-dated Treasuries or maintaining a neutral stance. "No one's aggressively extending duration right now," said Jay Barry from J.P. Morgan, emphasizing a shallower easing cycle.

Ahead of this week's Fed meeting, asset managers have reduced net long positions in longer-dated Treasury bonds while leveraged funds have increased net short positions on these maturities, according to Commodity Futures Trading Commission data. Overall, investors are steering clear of the far end of the curve, which is influenced by Treasury supply and long-term inflation expectations, according to Bory.

Many in the market are concerned about a revival of inflation under President-elect Donald Trump's administration, given his tax cuts and tariffs on imports. These policies are expected to broaden the fiscal deficit, impacting the long end of the curve and pushing yields higher.

"Tariffs pose an inflation risk by raising import prices, potentially leading to a one-time price shock or a sustained inflation source," explained Kathy Jones from Schwab.

BNP Paribas predicts U.S. CPI will reach 2.9% by the end of next year and 3.9% in 2026, partially due to tariffs. This forecast suggests that the Fed will remain on hold throughout 2025.

James Egelhof, BNP Paribas’s chief U.S. economist, highlighted the Fed's hesitance to ease given the robust economy and rising fears that monetary policy may already be nearing a neutral stance. "The Fed cannot overlook a tariff-driven temporary spike in inflation," he cautioned.