By Gertrude Chavez-Dreyfuss
NEW YORK (Reuters) – Bond investors, who expect the Federal Reserve to cut interest rates by a quarter of a percentage point on Wednesday, are bracing for a reversal of central bank easing in 2025 in anticipation of higher inflation under the administration. Trump.
Market players are staying out of longer-dated Treasuries as US inflation already looks firmer and they prefer to hold notes at the front to the middle of the curve, somewhere between two- and five-year bonds.
Fears of higher inflation typically lead to a sell-off on the long side, pushing yields higher as investors demand a premium to compensate for the risk they hold.
The Fed is widely expected to cut overnight rates by 25 basis points to the target range of 4.25%-4.50% at the end of a two-day policy meeting starting Tuesday. But what it does after this week’s meeting is an open question.
At least one bank – BNP Paribas – expects the Fed to keep rates stable throughout the year and resume interest rate cuts in mid-2026. Others see a reduction in financing costs of two or three quarters of a percentage point.
“An aggressive cut is consistent with what the numbers will look like, but also with potential policy changes from the new administration,” said George Bory, chief fixed income investment strategist at Allspring Global Investments.
“The Fed is trying to prepare the market for a slowdown in the pace of rate cuts and… increase its ability to monitor the data and be prepared for policy changes.”
Recent data shows that the US economy is resilient: a labor market that continues to create jobs and inflation, which remained too high to be comfortable in November. U.S. consumer prices rose 0.3% for the fourth month in a row in November, signaling that progress toward the Fed’s 2% inflation target has stalled.
Investors will also focus on the quarterly economic projections from Fed policymakers, including interest rate forecasts, also known as the “dot plot,” which shows how much easing is expected. The ‘dots’ from the September meeting, when the Fed started its easing cycle with a 50 basis point cut, showed a policy rate of 3.4% at the end of 2025.
The Fed raised rates by 5.25 percentage points between March 2022 and July 2023, pushing the policy rate to the 5.25%-5.50% range, to counter a rise in inflation.
“The Fed will be less forgiving in its summary of economic projections than it was in September, which is appropriate given the comments (Fed Chairman Jerome) Powell made that the economy is stronger than he thought when they cut by 50 basis points.” said Greg Wilensky, head of U.S. fixed income at Janus Henderson Investors, referring to the central bank’s rate cut in September.
“I believe they will increase points for 2025 by about 25 basis points from where it was,” said Wilensky, who noted that his bond portfolios are currently overweight sub-10-year maturities and underweight sub-10-year maturities .
NO-GO AT THE LONG END
Bond investors had been extending maturities or buying longer-dated assets throughout the year, preparing for Fed easing and a possible recession. As interest rates fall, bonds with higher yields become more attractive, causing their prices to rise.
For example, maturities of five to ten years are sensitive enough to capture price gains if interest rates fall, but also entail less interest rate risk than bonds with longer maturities.
More recently, however, some investors have reduced duration and focused instead on shorter-dated government bonds, or have remained neutral.
“No one is really looking to extend maturity aggressively right now,” said Jay Barry, head of global rate strategy at JP Morgan. “That’s a story about a more superficial easing cycle.”
At this week’s Fed meeting, asset managers reduced net long positions on longer-dated assets such as Treasury futures, while hedge funds increased net short positions on these maturities, data from the Commodity Futures Trading Commission show.
Investors are generally staying away from the very long end of the curve, which depends on government bond supply and longer-term inflation expectations, Allspring’s Bory said.
Market participants expect a new acceleration in inflation amid the incoming administration of President Donald Trump and its plan to cut taxes and impose tariffs on a range of imported products. These measures are likely to widen the budget deficit, put pressure on the long end of the curve and raise their yields.
“Tariffs pose a potential inflation risk because they cause import prices to rise. They could become a one-time price shock or an ongoing source of inflation,” said Kathy Jones, chief fixed income strategist at Schwab.
BNP Paribas expects the U.S. annualized CPI to reach 2.9% by the end of next year and 3.9% in 2026, partly due to tariffs. With higher inflation, the bank expects the Fed to remain unchanged in 2025.
The Fed has already shown “reluctance to ease,” said James Egelhof, chief economist at BNP Paribas, given the economy’s resilience and growing concerns that monetary policy could already be close to neutral.
“The Fed won’t be able to simply see through a rate-driven temporary increase in inflation,” he said.
(Reporting by Gertrude Chavez-Dreyfuss; Editing by Alden Bentley and Paul Simao)
