Upside inflation risks are receding while worries about the jobs market are mounting. The Federal Reserve is expected to respond with another 25bp interest rate cut on Wednesday, and could also bring QT to a conclusion.
Shifting Risks Point to Another Rate Cut
Given decent economic growth, elevated inflation, low and equity markets at all-time highs, you could be forgiven for questioning why the market is fully discounting a 25bp interest rate cut on Wednesday, with another 25bp cut priced in for December.
Well, the Federal Reserve resumed cutting at the September after a nine-month hiatus, which Chair Jerome Powell characterised as a “risk management” move. Above-target inflation is a problem, and tariffs continue to pose a threat, but it’s fair to say tariff-induced price hikes are not coming through as aggressively as feared.
The more pressing issue is the deteriorating jobs market, with a clear chance that the “low hire, low fire” economy becomes a “no hire, let’s fire” story. This jeopardises the “maximising employment” goal of the dual mandate, which could in turn prompt a weaker economy and risk the central bank undershooting its 2% inflation target over the medium to longer term.
A 25bp Rate Cut to Be Followed by Another in December
July and August customs revenue and goods import numbers imply a realised tariff rate of around 10%, well below the 18% rate estimate based on announced country and sector tariffs. The September customs revenue showed no sign of an acceleration, so it appears that there is a strong substitution effect already coming through – US companies switching to lower-tariff countries for their product sourcing, with the composition of imports shifting – or there is a temporary collection problem that may reflect a lack of resources.
The result is that companies are more able to absorb the cost increases, and there has been less impact on inflation than feared. This was confirmed with core inflation in the US rising a relatively benign 0.2% month-on-month in September. We expect the realised tariff rate to rise and goods prices to be more heavily impacted in the coming months, but a slower tariff pass-through gives more time for disinflationary factors to provide some mitigation. These include lower energy costs, weakening wage inflation and slowing housing rents.
In terms of jobs, the government shutdown has meant that we are not getting official statistics, so we are having to rely on third-party sources. The private payrolls series reported a net loss of jobs in three of the past four months, while the series also suggests a contraction in employment. Households are nervous, with a net 50%+ expecting unemployment to rise over the next 12 months. Business surveys aren’t painting a particularly upbeat picture of the state of the economy, so like the market, we expect the Fed to cut rates next week and follow up with another 25bp cut in December.
Source: Macrobond, ING
Two Further Cuts Expected in 2026
At the September FOMC meeting, the Fed updated its own forecasts with the median expectation of officials suggesting that these two cuts plus one more in 2026 would be enough to support growth while containing inflation. The market is sceptical, believing that a rapidly cooling jobs market will require more aggressive action. Around 125bp of potential cuts, taking the Fed funds rate down to 3%, are priced into Fed funds futures contracts for the end of 2026.
The positive spin is that looser financial conditions (lower Fed funds and Treasury yields coupled with dollar weakness) should support economic activity and clarity on trade results in corporates starting to put money to work again with a resumption of hiring. In such an environment, we may indeed only get one further rate cut in 2026 or possibly no further action. We retain a moderately upbeat outlook, but think it will take at least two more rate cuts next year to achieve that turnaround.
The more negative take is that we are wrong on tariffs, and that they start to have much more impact on prices in the short-term, which squeezes spending power and corporate profit margins. The downturn in economic activity intensifies with the jobs market deteriorating in such a scenario. If we experience an asset price correction, either in home prices or equities, this will need much more aggressive action to support the economy, with policy rates cut to well below 3%.
FOMC Decide on the Final Stages of the Quantitative Tightening Objective(s)
Renewed focus on liquidity management is likely to feature at this meeting. Bank reserves are now just under US$3tr, which is about 10% of , and should be comfortable. But the Fed won’t want to take too many risks, preferring to ensure that the excess of reserves is ample enough to support the system. Identifying the exact level enters the realm of the dark arts, but the Fed knows very well that the last time it tested the lower end, it took reserves down to just below 7% of GDP. At around that level, there was quite some consternation in repo when a moderate corporate tax payment date, along with some bills settlements, left the market short, causing severe spikes in the funding markets. With reserves at 10% of GDP, we’re nowhere near that, but a glide path that ensures we don’t go below 9% is required. That implies a tolerance of some $300bn of further reserves reduction.
As it is, there is some $5bn of Treasuries rolling off monthly. The cap on MBS roll-offs is $35bn, but the actual monthly roll-off has tended to run much lower than this, in the area of $15bn. So the current roll-off is about $20bn per month. At this pace, the identified $300bn of comfort would be exhausted in about a year. What to do?
The Fed is likely to completely end the roll-off of Treasuries. With respect to MBS, the issue is that the Fed would prefer not to have these on its balance sheet, and it currently holds about $2tr. The simplest thing to do is to hold its nose and keep it on its balance sheet. But it could also look at the option of maintaining the roll-off of MBS while at the same time engaging in buying of either Treasuries or T-bills. Probably bills, to avoid it being construed as quantitative easing. There’s not been much talk about this option, so if it materialises, it could prove quite supportive.
Market-wise, it’s unlikely that this FOMC meeting will be troubling for Treasuries anyway. The rate cut discount has remained solid, and there has been little objection to the notion that a series of 25bp cuts is coming down the track. The 2yr yield is holding in the 3.5% area, comfortable there, and if anything, tempted to edge lower. The 10yr is holding in the 4% area, and feeling secure for as long as the inflation data reasonably behaves. And the bigger near-term driver is coming from activity vulnerability. To the extent that the Fed focuses on this, and “ending QT”, Treasuries will come out of it in a reasonable mood.
Dollar Awaits Data More Anxiously Than the Fed Meeting
The US government shutdown and delayed data releases initially helped the dollar recover – less data meant less room to speculate on further easing. But the FX market has since lost direction. It’s quite possible that the eventual release of jobs data will prove more important for the dollar than the October FOMC itself.
Back in September, a well-telegraphed Fed cut triggered a sharp US dollar rebound. A repeat of that reaction looks less likely now, with positioning more balanced. Still, we see the balance of risks on FOMC day tilted to the upside for the greenback, as Powell may again err on the side of caution in his guidance and assessment of inflation and jobs.
We wouldn’t expect any FOMC-day USD rally to be particularly long-lasting unless the Fed delivers clear hawkish signals. Once the regular US data schedule resumes, we expect the broader information flow to point to renewed dollar softness, especially heading into a seasonally weak year-end. Our target for December remains 1.20.
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