On Wednesday the 17th of September, Federal Reserve decided to cut interest rates by 25 basis points. The decision was made with one dissenting member who is also the newest voting member. Despite the rate cut, markets are relieved due to no significant committee split at the FED as many were expecting.

The Trump administration has been pressuring the Federal Reserve to deliver deeper rate cuts than policymakers currently project. Pushing for rate cuts in times of solid GDP growth and labor market that is not as tight as before but still solid is highly unusual and contradictory. One possible motivation is debt financing. Cutting short-term rates lowers borrowing costs and makes debt refinancing cheaper. However, with budget deficits exceeding 5% of GDP – uncommon outside of wartime or recession – the long end of the Treasury curve should, in theory, push higher. As tariff-related uncertainty diminishes over time, U.S. companies could gain a structural advantage over importers, supporting stronger domestic growth, provided there is no significant retaliation. Also, due to lower migration which will probably lead to higher wage growth as well as higher bond yields due to above target inflation, next decade might be the years of 3% inflation with higher interest rates and solid growth as well as booming equity markets. As many others predict, normalization of rates after multi-decade bull run on bonds might be the narrative over the coming years. While bondholders may not face heavy losses, opportunities for outsized capital gains could be far more limited. Higher interest rates in developed markets would reflect healthier growth dynamics. At the same time, some distortions created by ultra-low rates – such as surging real estate valuations – may fade. Importantly, ultra-low rates have historically been a consequence of sluggish growth, not the result of a policy preference in itself.

On Thursday markets started to digest the news and communication by the FED following the new dot plot and rhetoric by Jerome Powell. The crux of his speech is related to labour market that is not solid as it was before and elevated inflation that is going up. Market reaction the next day was selloff across the curve with 2-year treasury yield going up by eight basis points by the end of the week. 10-year treasury yield rose by nine basis points. This raises the question: is the recent bull run in Treasuries reversing? Combined with tensions between the White House and the Fed, and the potential for court rulings to unwind tariffs (promoting curve steepening), conditions appear favourable for further selloffs at the long end. A similar episode occurred last September, when the Fed cut by 50 basis points, and markets judged it a policy mistake.

The result of expansionary fiscal policy and neutral to restrictive monetary policy without using unconventional monetary policy such as quantitative easing and deregulation wave should spur growth and equity markets should benefit significantly over the coming years. Bond holders won’t have such good sleep due to inflation, trade frictions and recency bias to 2010-2020 and potential no-return to 2% inflation in the medium term.