When the economy gets spooked and when stocks get battered, the classic trade that is seen in where interest fall as investors buy up more bonds for safety. This week’s massive drop in equities is over fears that tariffs and retaliatory tariffs in a trade war will result in a recession. That’s going to take a while to play out but bonds didn’t wait at all. Now the 10-year yield is down to 3.92% after having been at 4.2% just earlier this week — and interest rate cuts are now being pried in with a vengeance.
Strategic investors have rotated into the safety of bonds and steady dividend stocks that are unlikely to feel the crushing blow of tariffs like the economically sensitive stocks. This is hardly a reason to celebrate, but it it may come with a hidden upside from much lower interest rates ahead.
Fed Chairman Jerome Powell and the Federal Reserve have pledged to be data-dependent in hoping for inflation to be tame at 2.0% to 2.5% and for full employment. The bond market is now factoring in rate cuts long before Powell can even speak.
CME Fed Fund futures are now pricing in a sudden move to lower interest rates this year. The current 4.25% to 4.50% target range for Fed Funds may now be as low as a 3.00% to 3.25% range by the December 10, 2025 FOMC meeting.
A falling stock market and a slowing economy never feel good while they are happening. This week has been quite painful to investment and private retirement accounts that are loaded up with stocks. Quite painful.
Is there a bright side to the sudden plunge in equities? Maybe for the U.S. Treasury and its debt servicing costs. The high interest rate environment has added problems to the national debt and the debt servicing costs because paying the interest is now more than a $1.1 trillion annualized expense.
Where the actual rates will be by the end of 2025 will remain up for debate. As of now, the CME FedWatch Tool has a 32.0% chance that Fed Funds will be in a 3.25% to 3.50% range and a 38.2% chance that Funds will drop to a 3.00% to 3.25% range. That means the odds are currently favoring the lower range of 3.00% to 3.25%, but if you add these up the odds are now 70.2% that funds will be at the 3.25% to 3.50% or lower — a full point of rate cuts that is now being priced in.
CME FedFund futures are far from perfect. At the same time, they are actual odds based upon real money used to trade Fed Fund futures. It counts for something, similar to options for stocks.
These were the odds of where rates would be just a month ago:
- 3.25% – 3.50% at 22.0%
- 3.50% – 3.75% at 31.8%
- 3.75% – 4.00% at 25.1%
- 4.00% – 4.25% at 10.0%
The retaliatory tariffs being met by China with immediate tariff hikes on U.S. goods is certainly feeling like the start of a trade war. The S&P 500 and NASDAQ now in negative territory for year and down in the red from the “Trump Bump” after the election. It doesn’t feel good today and it may not feel good tomorrow. That doesn’t mean it won’t be better in a year or even sooner.
There is a potential problem in expecting too many rate cuts in too short of a period. The Fed will face a serious dilemma in cutting rates if inflation spikes from tariffs while the economy is stagnating or tipping into recession. Strategic investors are taking the risk-off approach at the moment.
