For several weeks now, we have been warning that the U.S. economy might be too strong for the interest rate cuts that the financial markets had priced in until yesterday. We pointed out that if the 10-year U.S. Treasury yield rises above 4.45% - 4.5%, it should be considered a red flag. Chart analysis suggests this could signal a further rise to around 5.4%. The 10-year yield has now risen to 4.52%, and if it does not soon fall back toward 4.35%, a breakout to the upside is likely. The question, of course, is what has caused this shift in sentiment. Until recently the markets expected four 0.25% rate cuts by the end of 2025. The 10-year yield was also expected to decline. Now, the Fed itself is pricing in three rate cuts, including the one yesterday, and the 10-year yield has not dropped, but has likely broken upward.
The main reason for this shift is that the Fed is estimating potential growth at around 2.2% for the coming years, while the economy is currently growing at about 3% according to the latest data (so the Fed is not particularly optimistic about how much AI will increase overall economic productivity).
Now that the economy is running at nearly full capacity, growth needs to be slowed to align with potential. The question is, why did the central bank even lower interest rates, and why will it likely do so again in 2025? This is probably because the Fed expects economic growth to slow for some reason. However, caution is needed here, as this slowdown has been predicted for a long time without coming to fruition. Likely factors preventing this include a large government deficit, loose monetary conditions (which are much more important for growth than the level of the federal funds rate), and slightly lower interest rates. One could also argue that the so-called "neutral rate" is much higher than the Fed had anticipated.
However, this is not the full picture. The Fed has clearly indicated that, at this point, its rate forecasts have hardly factored in various measures that Trump intends to implement, such as cutting tax rates, reducing immigration, and imposing import tariffs. Additionally, no account has been taken of the increased attractiveness of oil and gas drilling. These measures will likely further stimulate growth and drive up inflation. The Fed is still too uncertain to incorporate these factors into its forecasts. This also applies to other proposals Trump has made, such as shrinking the civil service and making the government more efficient.
The question is, how quickly can all this happen? The introduction of import tariffs and limiting immigration could occur quite quickly. The rest will need Congressional approval, where the Republicans hold a thin majority. This wouldn't be so problematic if they all agreed on these issues, but this is certainly not the case.
It is therefore likely that many of Trump's proposals will remain stalled in Congress for some time.
This creates a situation where the proposed measures to stimulate growth will likely be adopted quickly, but the measures needed to finance them will take considerably longer. Therefore, we expect that if the Fed lowers rates again in the near future, the next step might well be a rate hike.
Looking at Europe, the economy is barely growing, and there is significant uncertainty due to upcoming elections in Germany and France. Government deficits are too large and need to be reduced, especially in France. Given the aging population, higher defense spending, rapidly increasing interest payments, more spending on climate change mitigation, and the prospect of import tariffs from the U.S., this situation is difficult to resolve. The only solution seems to be that the ECB will continue lowering rates to stimulate the economy. Given the current low growth, this will likely be possible. Rising government deficits will further stimulate the economy, and the result is likely that the European economy will experience steady growth in the coming quarters and years—something that has not been widely anticipated.
Against this backdrop, we see the interest rate differential between the U.S. and Europe continuing to widen, and therefore expect the euro/dollar exchange rate to decline below parity in the near term. If the European economy starts to recover later, we expect the trend for euro/dollar to reverse and move upward. It is also important to note that interest rates in the U.S. are likely to continue rising, while those in Europe remain under downward pressure. This could soon lead to a significant improvement in the performance of European equities relative to U.S. stocks. In the U.S., the trend for the S&P 500 may have already shifted from upward to downward, especially if the index falls below 5600.
We wish everyone a very Merry Christmas and a Happy New Year.