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Written by: David Stonehouse | AGF
What’s your expectation for U.S. monetary policy heading into the final quarter of 2025?
The U.S. Federal Reserve (Fed)I s virtually certain to resume its rate cutting cycle when the Federal Open Market Committee (FOMC) meets on September 16-17. This is hardly a contrarian view, especially after the most recent U.S. nonfarm employment report showed just 22,000 new jobs were added in August, and that the U.S. economy lost jobs in June for the first time since December 2020. Indeed, the market is currently fully pricing in a 25 basis point (bp) rate cut, with a small chance of a 50bp cut this month.
After a year on hold, having the Fed rejoin the roughly 90% of global central banks that are currently in easing cycles (per Ned Davis Research) should be welcome news for the global economy. Still, some investors may be underestimating the extent of easing that could be in store if the Fed’s focus is more on labour market softness than inflation data, just as Fed Chair Jerome Powell suggested it would at the Fed’s annual Jackson Hole conference last month. If anything, the Fed may just be getting started on what could be a meaningful easing cycle over the next year or so.
Are you confident that the Fed continues to act independently as it contemplates its next moves?
FOMC members have always cherished their autonomy to conduct monetary policy without political influence. However, Fed governors are presidential nominees approved by the Senate, and the Fed Chair testifies to Congress twice a year, so there are clearly some political overtones as they conduct their duties.
Nevertheless, the Fed has not been subjected to such overt attempts to exert influence as the Trump administration is pursuing in many decades, if ever. Trump’s badgering of Chair Powell to slash interest rates aggressively or to step down, as well as his attempt to fire Governor Lisa Cook following accusations of mortgage improprieties, demonstrate this. Moreover, his nomination of close advisor Stephen Miran to replace Governor Adrian Kugler, who resigned last month, could give Trump a majority of the seven Fed governors who will have been appointed by him if Cook is removed or if Powell resigns his governorship following the end of his chairmanship next May. Trump has clearly stated his desire to control the Fed governors to pursue aggressively lower interest rates.
While it is reasonable to argue that Fed governors would remain committed to conducting policy to meet the primary goals of maximum employment and stable prices regardless of Trump’s coercion, there is a lot of room to interpret what level of interest rates is needed due to uncertainty about future economic data and changing policy priorities. Therefore, Trump governor appointees could well justify more easing than others might expect or believe appropriate.
What are the implications of a more aggressive Fed on the economy and capital markets?
First, sizable rate cuts should stimulate the U.S. economy, which is also poised to benefit from President Trump’s One Big Beautiful Bill Act as it takes hold and provides significant tax cuts and other fiscal incentives meant to spur economic activity. Of course, that backdrop is more likely to support U.S. equity markets over the coming year, while lower rates should also result in short-term Treasury yields continuing to decline from current levels. Moreover, the U.S. dollar could resume its weakening trend in the medium term.
That said, investors might be concerned that long bond yields will rise because the combination of lower rates and greater fiscal stimulus could lead to higher nominal growth (both more inflation and faster real growth). And this dynamic is further complicated by ongoing worries about fiscal deficits, which may contribute to higher long-term yields in the future.
Yet these fears could end up being overblown. Indeed, longer-dated Treasury yields have remained relatively range bound in recent years and have absorbed these concerns remarkably well so far this year, with 10-year yields falling nearly 50 basis points and 30-year yields down about 10 basis points as of September 12.
Furthermore, if the Fed does cut interest rates significantly, 2-year Treasury yields would very likely also decline by a meaningful amount. Even a modest rise in long bond yields in that scenario could result in a yield curve that would be steeper than it has been on average historically. And a more substantial rise in long yields could therefore be constrained by the historical limits of yield curve steepness, although we are still a long way from that.
But here’s where another aspect of Trump policy could come into play. A U.S. Treasury led by Secretary Scott Bessent and aided by a compliant Fed could keep a lid on long bond yields using several different tactics. These measures could include both the Treasury and the Fed buying long bonds, the Treasury issuing mostly short-term bonds and limiting long-term issuance, the Fed stopping its quantitative tightening program, or other actions. In other words, the Trump administration’s desire to reduce interest rates to contain interest costs on U.S. government debt and consumer mortgages can’t be ignored as an influencing factor that could prevent yields from rising significantly higher on the long end of the curve.
Rising yields could still present challenges for the economy and investors, but it may turn out that the interest rate backdrop over the next year or so ends up not being as problematic as some observers anticipate. In fact, we would not be surprised if U.S. bonds deliver another year of coupon clipping returns, which has broadly been the case since the substantial 2021-22 rise in yields.
Related: The Job Market Looks Weak—But Earnings, Income, and Stocks Say Otherwise