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Back in September, the market priced in one of the most aggressive cutting cycles I've ever seen, with multiple 50 basis point cuts that would quickly take us to 3% on the federal funds rate in 2025. Fast forward to today, it's... A completely different story, with one or two pieces at the best prices for 2025.

Let's dive into the reasons behind the change and what to expect.

Below is a chart comparing the effective federal funds rate (EFFR) versus two-year Treasury bills.

There are some takeaways we can get from comparing these two crops:

• Over the past couple of years, we have seen many moments where two-cents were priced into an impending and aggressive cutting cycle (as seen when two-cents drop below EFFR).
• For the first time since mid-2022, we see these two returns being equal. This means that the market is pricing in an interest rate cutting cycle that is essentially over, but sees no opportunity for any upside either.

One big driver behind the talk of a quick end to this short-term downturn is surprisingly stubborn inflation. As we see in the December Economic Outlook summary, FOMC members have shifted forcefully from seeing inflation as broadly balanced to seeing risks weighted to the upside.

This, coupled with what has proven to be a more resilient and rigid labor market than appeared in September when the FOMC began cutting interest rates, shifts the distribution of potential outcomes toward a tightening monetary reaction function.

Putting these pieces together highlights why there is growing conviction that the cycle of interest rate cutting is over.

However, there are still pessimistic voices within the FOMC.

In his speech this week, Governor Waller stated that he still believes in lowering interest rates this year: “So what do I think? If the outlook develops as I have described here, I will support continuing with rate cuts in 2025. The pace of those cuts will depend on how far progress is made.” We make progress on inflation, while keeping the labor market from weakening.

As has happened in the past two years, it looks like 2025 will be another The year of extremism As the market moves from aggressive pricing to aggressive dovish.

Investors will need to decide quickly whether to try to ride these changes in sentiment or ignore them as noise.

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