Why the likelihood of more US rate cuts is diminishing

Donald Trump isn’t backing away from his pledge to impose tariffs on imports and the uncertainty that’s generating is against a backdrop of fading expectations of further US rate cuts.

Donald Trump and and wife Melania are just days away from returning to the White House. Picture: AFP

The US president-elect hasn’t denied the latest report that his team is considering a measured approach to tariffs but shows no sign of backing down from his commitment to massive increases either.

As markets await clarity on Donald Trump’s policies, there’s no evidence he plans to retreat from his aggressive plans for trade and immigration before his inauguration next Monday.

While he hasn’t dismissed Bloomberg’s report indicating that a measured approach to tariff increases is being considered, Trump seems intent to honour his pledge for large-scale and widespread tariffs, calling for an “External Revenue Service” to collect tariffs on foreign imports.

“I will create the EXTERNAL REVENUE SERVICE to collect our Tariffs, Duties, and all Revenue that come from Foreign sources,” Trump posted on his Truth Social network on Tuesday.

“We will begin charging those that make money off of us with trade, and they will start paying, FINALLY, their fair share. January 20, 2025, will be the birth date of the External Revenue Service.”

Bloomberg on Tuesday reported that members of Trump’s incoming economic team were discussing slowly ramping up tariffs month by month – a gradual approach designed to boost negotiating leverage while helping avoid a spike in inflation.

While markets could reverse some of their recent trends if Trump’s policy statements next week are no worse than expected, they have been unwilling to jump the gun to any significant degree.

Meanwhile there was plenty of uncertainty about the US interest rate outlook before Wednesday’s release of US CPI data showing PPI components that map core PCE were mixed.

RBC Capital Markets said its call for one more cut in the Fed funds rate at the January meeting was already skating on thin ice before the surprisingly hawkish December Federal Reserve Open Market Committee meeting and stronger-than-expected US jobs data.

“Quite simply, the data just haven’t given any cover to cut again, particularly after December non-farm payrolls last week came in very strong,” RBC head of US rates strategy Blake Gwinn said.

“We’ve heard Fed speakers repeatedly emphasising these words like cautious, gradual, careful, and really suggesting that they’re looking to slow the pace of cuts.”

FOMC minutes last week showed that a substantial majority of officials think they’re well positioned to take their time in assessing the outlook, indicating they might be setting up for a pause in cuts.

“There might have been a possibility that the data gave them some excuse to get one more cut in,” Mr Gwinn said.

“But at this point it doesn’t really look like there’s going to be the case.”

Another concern was the persistence and substantial steepening of the US yield curve since December. That reflects growing concerns about deficits and Treasury supply of bonds, and that the Fed is making a dovish policy error with inflation expectations starting to push up long, dated yields.

But to some degree that’s “retrofitting a narrative on to the price action”, Mr Gwinn said.

In other areas of the market where both of those themes ought to show up in price action – such as asset swaps which should move on deficit expectations and longer-dated inflation expectations that should be rising if the Fed was seen as kind of losing control or being stubbornly dovish – there haven’t been the kind of moves that would support those narratives.

“We did have a lot of supply to start the year, so markets were having to absorb not only Treasury issuance – we had a round of long-end bond auctions, but also a lot of investment grade issuers coming to the market, so that probably gets kept some upward pressure on yields,” Mr Gwinn said.

“I think there was some pressure coming from overseas, so some of this wasn’t even necessarily a US story. And we’ve seen at times both bonds and gilts underperform Treasuries.

“So doesn’t even necessarily seem like it’s a US specific story.

“I also think there’s a bit of a buyer strike starting off the year; a lot of these kind of would-be dip buyers, your big, real-money type investors are probably a bit slow to get started in the year, and probably aren’t interested in catching the falling knife – particularly at the first few weeks of the year.

“And also that’s probably where you have these kinds of nebulous concerns around what Trump’s policies are going to look like, and their impact on budget deficits and inflation.

“Maybe that’s kind of circling around inside of that buyer strike.

“And providing one more additional reason for would-be buyers to kind of sit on the sidelines for the time being is this kind of focus on term premium. I think the reason we’re steepening is just because we have priced out about as much in terms of rate cuts as the market’s willing to price out.

“The market’s not really willing to start thinking about rate hikes at this point.

“So the front end of the yield curve is kind of capped and so when we get positive data and hawkish Fed comments, the selling pressure hitting the back end a lot more than the front end just because the markets aren’t really ready to kind of go into thinking about the potential for hikes just yet.”

BofA for one now says the risks are skewed toward the next move being a rate hike.

“In our view, hikes will be in play if year-over-year core PCE exceeds 3 per cent and long-term inflation expectations become unanchored,” said BofA’s US rates strategy team, led by Mark Cabana.

Originally published as Why the likelihood of more US rate cuts is diminishing