How the Fed’s 2025 Outlook is Reshaping Markets and Trader Sentiment

The Fed’s re-introduction of right-tail (inflation) risk into the macro debate is a development, with a 30bp (to 2.5%) increase to its 2025 median core PCE inflation forecast getting real attention. Subsequently, the market will set equal sensitivity to upcoming US CPI, PPI and PCE inflation prints as it does to the US nonfarm payrolls report.

Have the Fed become politicized in their views?

If measures to reduce immigration are set to theoretically weigh on US growth, and tariffs will lift the price level of imported goods, and with various Fed members incorporating tariff risk into their economic assumptions, then the equity risk premium needs to be repriced, and that is happening.

With the knowledge that some Fed members have taken such a proactive step in its assumptions, part of the discussion on the floors has centred on the idea that the Fed has taken a step towards becoming a more politicised entity. The prospect then of Trump bringing this dynamic up in an upcoming speech seems elevated, but the fact that certain Fed members are now prophesising and incorporating these highly unclear assumptions of the future into their models, and moving away from its more reactive stance, seems a significant and highly questionable development.

As is always the way, the algo’s got the party started during the FOMC statement release and immediately took its steer from the Fed's new set of dots, with the 2025 median ‘dot’ revised to assume 50bp of cuts through next year – a big call relative to both market pricing and the consensus view held by economists. As more intel came to light, we then heard that the 25bp cut (seen at this meeting) was far closer to a hold than what markets had expected, with dissent coming from Cleveland Fed President Hammack, as well as three non-voters who also called for no cut.

US swaps pricing suggests one Fed rate cut in 2025

It seems that the barrier to ease the fed funds rate again in Q125 has been suitably raised and voila, the Fed has injected a high degree of uncertainty into interest rate pricing. US interest rate swaps now price the next 25bp cut by July 2025, with just 31bp of implied cuts for the full year.

Many will disagree with this implied pricing and feel the rates market may have gotten a touch emotional and the collective will possibly see things differently with the US data set to roll in through January. However, rates/swaps traders are seeing a greater sense that the Fed is more likely to be done on its easing cycle. We should then consider that US equity and broad risk should continue to work even if the Fed doesn’t cut from here, as long as it’s driven by compelling growth and consumption trends – however, if the Fed is holding off on a belief that we're seeing an end to disinflation, then equity faces renewed headwinds and drawdown.

The hawkish outcome not only saw US rates reprice, but we’re seeing long-end Treasury yields breaking key upside levels, with US 10-year real rates now at 2.19%. The pace of the selling in USTs has been a massive green light for FX traders to reengage with USD longs, and they have done so liberally, with EM FX being carved up. It wasn’t just LATAM FX, but the AUD and NZD were taken down too, with the technical setups on the higher timeframes looking ugly.

AUDUSD getting strong client attention

Our flows on AUDUSD have notably ramped up, with a now clear skew to fade the weakness, with many feeling the move into 0.6200 is overcooked and due a touch of reversion to the mean. For me, selling rallies into 0.6270 looks compelling, and with the AUD trading as a cheap CNY (yuan) alternative, if the prospect of a further weakening of the yuan looks elevated - subsequently, the flow-on effect for the AUDUSD to break 0.6200 also looks high.

FX volatility has lit up, and rightly so – if the Fed really are a step closer to an end (of easing), then we move towards a more dispersed world of central bank policy settings. The idea of central bank divergence could be the major macro theme for 2025, and one that typically promotes yield spread widening in respective bond markets - where the yield advantage commanded to hold US Treasuries over its G10 peers has the potential to blow out. In turn, yield spread widening incentivises increased USD buying flows.

With the NAS100, Russell 2k and S&P500 all having 3.5 standard deviation declines on the day, it’s clear that the options market played a major part as to the extent of the moves, with the street having to review and manage its punchy short volatility position. The reaction in the 1-day VIX was extreme, with the index pushing up a massive 32 vols on the day, with the VIX index rising 11 vols to 27% - a 5 standard deviation move. Again, this speaks to a market that has covered short volatility bets hard and reversed the position to price greater uncertainty and the more unpredictable period ahead.

All pretty ugly, and perhaps this is the signal that active equity manager players are calling it a day on 2025, and dialling back on risk, raising cash allocations and/or increasing portfolio hedges.

Was the move in markets overdone?

Another school of thought is that we’ve seen numerous case studies in the past 2 years where we see outsized moves on Fed Day, driven by positioning, reduced liquidity and various hedging flows, only for the collective to see things in a different light in the following session and as calmer heads prevail. It's hard to say if this plays out in the session ahead, but USD longs are taking some off the table in Asia, gold is +0.9%, while S&P500 and NAS100 futures are unchanged, with no follow-through selling.

The ASX200 underperforms in Asia

Looking at markets in Asia, while we are seeing a sea of red in Asia equity bourses, there is very little panic, or mass de-risking and we’ve seen the Nikkei225 come off its earlier lows. There has certainly been a more pronounced drawdown in the ASX200 (-1.7%), with the index hitting a low of 8125, before moving in a tight range into the close. Volumes through the ASX200 have been impressive at $10.8b on the day. We’ve seen an element of traders liquidating profitable longs and reducing gross long exposures in Aussie equity, with the selling broad-based across all sectors, with banks and materials taking out the bulk of the points.

So, all said, the Fed meeting injects some uncertainty into its policy setting for 2025 and promotes the idea of higher cross-asset volatility in Q125. However, a benign US core PCE print (tomorrow) and a weaker December US CPI print (due 15 Jan) , backed by a supportive tone from the centrists Fed speakers and the markets may move back to thinking the ‘Fed put’ is still very much in play, and that metaphorical hug could lift risk into US quarterly earnings on 15 January.

As always, an open mind on developments is critical.

Good luck to all.