The US Federal Reserve cut the benchmark fed funds rate by 25bp, as expected, at its recent policy meeting. But it also signalled only one cut next year, in contrast to market expectations of up to three. Time will tell which forecast turns out to be the right one.
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The Fed meeting was interpreted as dovish, so the US bond yield curve has bull steepened. The outlook remains uncertain, with economic data releases still delayed after the recent federal government shutdown.
Upcoming numbers (non-farm payrolls, consumer price inflation and third-quarter growth) may not meaningfully clarify things as the data is expected to be distorted by the shutdown itself.
We will have to wait for December data — to be published in January — before having a firmer view on the state of the US economy.
The Fed’s ‘dot plot’ of policymaker views showed there was a wide range of opinions on the level of the fed funds rate at the end of 2026 among members of the Federal Open Market Committee (FOMC). The options for the next meeting in January are nevertheless either that the Fed keeps rates on hold, or cuts them again, rather than hikes rates.
Encouragingly, growth forecasts have been upgraded even as expected inflation was trimmed slightly. The Fed’s view on the inflation outlook appears to be that tariff-induced goods inflation will eventually fade, while services and wage inflation are moderating.
Market reaction
Equity markets are likely to be pleased with the outcome. The Fed’s comparatively dovish tone should reassure investors that the outlook is still for a lower policy rate, even as inflation remains above the central bank’s target (which is good for corporate revenues).
This trajectory contrasts with the more hawkish tone recently from the Eurozone, where there has been talk of higher policy rates in 2026. We expect the evolution of inflation not to warrant such a move, but the strengthening of the euro over the last few weeks may partly reflect divergence in messaging (see Exhibit 1).
The prospect of a lower fed funds rate should provide renewed support for those equity indices most sensitive to interest rates, namely the technology and US small-cap indices. November’s sell-off, triggered by renewed worries over a bubble in artificial intelligence (AI) stocks, pulled the main US small-cap index down in sympathy.
The fundamentally positive outlook for US small caps is nonetheless unchanged: resilient consumer consumption, redirection of demand to domestic production because of the tariffs on imports, and increased business investment in AI sectors and in manufacturing (again due to tariffs).
This backdrop may explain why the small-cap Russell 2000 index has already surpassed its October peak. while both US and emerging market (EM) tech stocks are still (slightly) below (see Exhibit 2).
The prior rally in EM tech stocks had been particularly strong for South Korea (the MSCI Korea index is up by 85% so far this year), so it may take slightly longer for stocks to recover all the lost ground, but we do not subscribe to the AI bubble story.
Japan is a special case among the best-performing indices this year, with performance being partly driven by a weaker currency. The yen has dropped by 11% versus the US dollar since April even as the euro has strengthened by 1%.
Whether the yen can continue to weaken, and Japanese equities continue to outperform other developed market equities, will depend (as for the Eurozone) on the relative paths of monetary policy.
China trade data
One of the reasons we believe the Eurozone will more likely see disinflation than rising inflation in 2026 is growing competition from China.
The most recent trade data, showing the country’s trade surplus at over $1 trillion for 2025, pointed to a continued increase in exports to Europe (see Exhibit 3).
Unlike exports to ASEAN, which may be partly re-exported to the US, exports to Europe are likely to be sold in the region. This is increasing competition for domestic producers, dragging down GDP growth, and adding to the existing disinflationary pressures from US tariffs and a strong currency.
The hope is that the stimulus to Eurozone economic growth from higher infrastructure and defence spending will offset these factors.
Even here, the impact on growth from greater defence spending will be mitigated by increased imports from the US as European companies are not yet large enough to absorb all the additional defence spending. Regulation, bureaucracy, and constrained labour markets also loom large over the region’s outlook.
