The Trump shadow hanging over Wall Street’s meltdown

Investors got what they expected from the Federal Reserve Board when it cut US interest rates for the third time this year – but promptly spat their dummies.

The sharemarket fell almost 3 per cent, with the tech-oriented Nasdaq index tumbling by 3.6 per cent and an index of the biggest of the mega-tech stocks by 4.2 per cent. Bond yields rose after the Fed cut the federal funds rate (akin to the Reserve Bank’s cash rate) by 25 basis points. The US dollar soared, sending the Australian dollar to two-year lows.

Wall Street tumbled after the Fed shifted its thinking for 2025. Credit: Reuters

Futures markets had, ahead of the Fed’s decision, priced in a cut of that size and were pricing in two similarly sized cuts for next year, in line with the latest projections of the Fed’s Open Market Committee (FOMC) that sets monetary policy, so the reaction was, at face value, somewhat puzzling.

In a market where the big tech companies that have driven prices to record levels are trading on multiples close to 50 times their earnings, shares priced for perfection are highly sensitive to shifts in sentiment and interest rate expectations.

While the Fed’s projections might anticipate two rate cuts next year, after the release of its projections and its chair Jerome Powell’s news conference, futures market were pricing in only one and yields on both two and 10-year bonds spiked about 10 basis points despite the latest cut to the federal funds rate. That might help explain what transpired in the markets and why one observer described the decision as a “hawkish cut.”

When the Fed last released its projections in September, the median projection from the 19 members of its board was for the two 25 basis point cuts they delivered in November and December to follow the 50 basis point cut in September that began this rate cycle.

Those September projections, contained in the Fed’s famous “dot plot”, also showed, however, that most members had pencilled in four 25 basis point cuts next year. Now, they expect only two next year and two more in 2026.

What’s changed? Inflation is proving more stubborn than anticipated, effectively flat-lining in recent months, while the jobs market has proven more resilient than expected, and the economy has performed more strongly than expected.

More growth this year and next (the FOMC raised its projection for real GDP growth this year by half a percentage point to 2.5 per cent from its September projection) and less unemployment (4.2 per cent from 4.4 per cent) than anticipated are a mix that, if sustained, would limit the extent to which US rates could be cut because they would flow through to higher than previously expected inflation rates, which is what was reflected in the latest projections.

Where the median projection in the Fed’s dot plot for its preferred measure of inflation (one that excludes volatile food and energy prices) was for an inflation rate of 2.2 per cent next year, it is now 2.5 per cent.

Powell, who said the decision to cut was a “closer call” than at previous meetings, made it clear that a chapter in the Fed’s thinking about inflation and interest rates has ended and that it would now be more cautious about future changes to rates.

“Our policy stance is now significantly less restrictive,” he said.

“We can, therefore, be more cautious as we consider further adjustments to our policy rate. From here, it’s a new phase.”

There’s good reason for caution, given core inflation is still running at 2.8 per cent and that, from January 20, Donald Trump will be in the White House and has promised that he will immediately start implementing his contentious and punitive tariff and immigration policies.

President-elect Donald Trump’s imminent return to the White House has triggered some caution at the Fed. Credit: AP

He has also pledged to extend and even increase the massive tax cuts he enacted in 2017 that will expire next year unless extended.

As a package, those policies could be – almost certainly would be – highly inflationary if implemented, and it isn’t out of the question that, instead of continuing to cut rates next year and in 2026, the Fed might again be forced to raise them.

Interestingly and unusually, Powell admitted at the news conference that some Fed policymakers had already started to incorporate the potential impacts of higher tariffs in their projections.

Trump has promised baseline tariffs of 10 to 20 per cent on all imports and a 60 per cent rate on imports from China, although that could be as much a bluff – leverage in trade and other negotiations – as his real intention.

The Fed and the rest of us won’t know how real Trump’s threats are and how significant their impact might be until some point next year.

As Powell said, the impact of Trump’s policies is, at this point, highly uncertain.

“We just don’t know, really, very much at all about the actual policies. So it’s very premature to try to make any kind of conclusion,” he said.

On current settings, assuming some improvement in the inflation rate, the likely next cut to US rates would occur quite early next year, perhaps at the Fed’s January meeting or, more likely, in March.

Federal Reserve chief Jerome Powell is walking a tightrope.Credit: Bloomberg

The question mark over Trump’s agenda won’t, however, be dispelled in the first few months of next year, which probably means that any further movement in the federal funds rate – whether down again or up – may not occur until the middle of next year.

Until a clearer picture emerges of the economic impacts of the new Trump presidency, there will be a lot of uncertainty – and considerable vulnerability for sharemarket investors in particular – within financial markets.

An interesting aspect of the Fed’s projections is that the median projection for the federal funds rate beyond 2027 is 3.1 per cent, an increase from September’s 2.9 per cent.

While that is significantly below the effective funds rate at present of 4.58 per cent and the range now being targeted by the Fed of 4.25 to 4.5 per cent, it reflects a “neutral” rate – the policy rate that is neither expansionary nor contractionary – that is higher than its September estimates and therefore closer to the current federal funds rate than the Fed previously envisaged.

Leaving aside any impact from what Trump might or might not do, that would imply less scope for rate cuts than previously expected.

If there is a new, Trump-inspired surge in US inflation, the neutral rate would move higher again, along with the federal funds and market rates, and the Fed would find itself, once again, in Trump’s crosshairs.

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