No Guarantees on Fed Cuts from Here: How to Play a Pause
A Fed that is less likely to ease may mean additional headwinds for broad risk assets
Key Takeaways
- There’s a good chance the market is misreading the Federal Reserve. U.S. swaps pricing implies multiple Fed cuts through 2026, but strong growth (~4%, Q31) and inflation near 3% suggest a limited need for aggressive easing.
- Our own feel is that the short-term U.S. neutral rate is higher. That suggests that the Fed funds rate stays higher for longer.
- Portfolio Implications: Position defensively— we favor Quality/low volatility equities, Health Care and Staples. Expect U.S. dollar (USD) strength and pressure on the front end of the UST yield curve.2
We recently rewatched the classic filmRaiders of the Lost Ark, and couldn’t help but draw a comparison between market participants expecting the Fed to cut rates aggressively to Indiana Jones running away from the boulder toward safety in the opening scene.
Indeed, if we examine current pricing for the Federal Open Market Committee (FOMC) in the swaps market, there is a 63% chance that the Fed will cut by 25 basis points (bps) at the December meeting. What’s more is that the market expects a gradual easing throughout 2026 to take the Fed funds rate below the 3.0% level by the end of next year (from an effective rate of 3.9% now). Stop counting on your fingers, folks – that equates to four more cuts from here (see Chart 1).
Chart 1 – Market Implied Fed Funds Rates for 2026 FOMC Dates
Source: BMO Global Asset Management, Bloomberg.
But if you look at the body of evidence presented in the data so far, it’s not so clear that the Fed should be easing by that much.
While we won’t have a preliminary estimate for Q3 growth until December, current nowcast trackers have it coming in at just above 4%.1 If true, that would mean that the U.S. economy has averaged just over 2% growth (Q/Q, annualized) over the past four quarters. Certainly, we can attribute a fair chunk of that to AI-related capex, but the available retail sales data also tells us that consumer spending also played a key role in driving that growth.
Economic growth at that clip shouldn’t be something that concerns the Fed.
The Bureau of Labor Statistics (BLS) did cancel the release of the October Consumer Price Index (CPI) print, but it’s unlikely that would have provided definitive proof that the Fed is making progress on it’s inflation mandate. Both CPI and PCE (another key inflation measure3 ) are currently tracking closer to 3% as opposed to the 2% target (Chart 2). Also, household expectations of longer-term inflation are still a bit too high for comfort. The textbook would suggest that the Fed needs to keep rates on hold at this point.
Chart 2 – Both CPI and PCE Are Still Well Above the Fed’s Price Objective
Source: BLS, BMO Global Asset Management, as of October 31, 2025.
Arguments in favour of Fed rate cuts through 2026 lean heavily on two assumptions: first, that the labour market is showing signs of stress, and second, that politics will inevitably encroach on decision-making.
On the first point, we’ll concede that the labour market is showing some strain (the unemployment rate is trending higher). However, the updated claims data show that we’re still far from a point where slack is building materially in the U.S. jobs market. At the very least, this implies that the disinflationary impulse from a softer labour backdrop will be slower than what many expect. On the second point, remember that Trump replacing Powell with someone more politically aligned will still represent just one vote out of 12. The Fed deliberates by majority and a Fed Chair has been outvoted before.
So, what does all of this mean? It tells us that the nominal neutral rate in the short-term is likely higher than what many think. If that is the case, then current monetary policy conditions are likely not as restrictive and there’s little reason to expect the Fed to cut by much more going forward.
And to be fair, it does feel like the equity market is picking up on this point. A Fed that is less likely to ease may mean additional headwinds for broad risk assets. If we are correct – then the tactical path forward is clear - tilt your portfolios to be a bit more defensive as we ride out this wave of caution. That will mean the following:
- Quality and low vol outperform as strategies in the coming period (ZUQ and ZLU).
- Health Care and Staples should continue to shine (ZXLV and ZXLP).
- The U.S. dollar rallies (trim your hedges, please).
- The front-end of the UST curve should come under pressure in the near-term.
Tying this back to our intro, an infamous pop-culture joke is that Indiana Jones is actually irrelevant to the outcome of the story ofRaiders of the Lost Ark. In the end, the bad guys ended up finding the Ark anyway and were still destroyed while the hero was tied up. That’s an apt takeaway for anyone that wants to be too activist in a period where the market is likely misreading the Fed.
Performance (%)
Ticker |
Year-to-Date |
1-Month |
3-Monts |
6 Month |
1-Year |
3- Year |
5- Year |
10- Years |
Since Inception |
Inception Date |
6.70% |
-1.96% |
3.24% |
4.66% |
6.66% |
8.42% |
11.12% |
10.00% |
13.39% |
2013-03-19 |
|
10.75% |
2.85% |
8.99% |
19.35% |
15.55% |
25.83% |
17.42% |
15.76% |
16.68% |
2014-11-05 |
|
Returns are not available as there is less than one year’s performance data. |
2025-02-04 |
|||||||||
2025-02-04 |
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Source: Bloomberg, as of October 31, 2025
1 Atlanta Fed, GDPNow, as of November 21, 2025.
2 The UST (U.S. Treasury) yield curve: a line graph that visualizes the interest rates of U.S. government debt, showing the relationship between the yield and the maturity of Treasury securities.
3 PCE inflation: a measure of inflation based on the Personal Consumption Expenditures (PCE) Price Index, which tracks the prices of goods and services purchased by U.S. consumers.
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