Interest Rate Update

Yesterday’s FOMC announcement was uneventful, as evidenced by term rates ending the day unchanged.  However, rate cut expectations for 2026 have been changing quite a bit over the past few weeks.  At the end of December, markets were looking for 2.8 cuts by January 2027 and that has moved down to 1.8 cuts in recent weeks.  The main driver of this repricing has been better than expected US Economic data.  To this point, the updated FOMC statement mentioned that economic growth was “expanding at a solid pace” and also an upgrade to the statement on the labor market stating that the unemployment rate “had shown some signs of stabilization”.  During Fed Chair Powell’s press conference he reiterated that the Fed will continue to be data dependent and that the current target rate is “within a plausible range of neutral”.  This debate at the Fed about the appropriate neutral rate, for the current environment, is what will drive their decision making process for the balance of the year.  Fed Chair Powell only has two remaining meetings on his term and, based on commentary during the press conference, it seems likely the December cut was his last as Fed Chair.  Current market expectations support this view as the forward curve is only building in one cut in June or July and partially pricing in one further cut in 1Q27.  

The market is still eagerly awaiting further information on who will be the nominee for Fed Chair in May.  It sounds like that announcement will be coming within the next week.  Expectations for the new Fed Chair have evolved in recent months.  For most of 2H25 Kevin Hassett, considered to be the most “Trump friendly” candidate, was leading the field.  In recent weeks, he has moved down to only a 7% probability in prediction markets with Rick Rieder and Kevin Warsh having roughly equal probabilities of being the next Fed Chair nominee.  Both of those candidates are viewed as more independent choices compared to Hassett.  Further complicating the calculus is Fed Governor Lisa Cook’s status and whether or not Fed Chair Powell will stay on the board of governors.  Ultimately, the market will serve as a check on the potential for a Fed Chair to cut in a manner that isn’t supported by economic data.  

Term rates have been slowly marching higher over the past few months.  Generic 5y swaps hit their recent low of 3.19% on 9/8 and traded as high as 3.59% earlier this month before retracing to 3.54% currently.  We’ve started to see some economists forecasting that the Fed is done with cuts for this cycle and predicting hikes starting in 2027.  Historically, the Fed is on hold for about 12-18 months from the last cut to the first hike of the next cycle.  If markets start to price out current expectations for an additional ~45 bps of easing, there is potential for term rates to move up from here.  Looking ahead, we’ll get the majority of January US Economic data over the next two weeks so we expect recent volatility to continue.

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