As expected, the Federal Reserve (Fed) cut interest rates last week to take the fed funds rate down to 4.25% (upper bound). Moreover, through the release of the updated dot-plot, the Committee signaled that two more interest rate cuts could be appropriate this year, which would take the fed funds rate down to 3.75% (upper bound). The cut was the first rate reduction since last December and the continuation of the rate-cutting campaign that began last September, which has so far seen an unusual reaction out of the Treasury market.
When the Fed delivered its first 50 basis point rate cut last September, bond markets responded in a way that defied four decades of precedent. Instead of falling as expected, the 10-year Treasury yield surged, creating one of the most counterintuitive market moves in recent memory. The progression was relentless: 45.5 basis points higher after 25 days, 78.6 basis points after 50 days, and 93.7 basis points after 100 days. The 10-year Treasury yield ultimately rose by over 100 basis points from its then September lows.
This move was remarkable not just for its magnitude, but for breaking historical patterns. In the previous five Fed cutting cycles dating back to the 1980s, the 10-year Treasury yield declined, on average by nearly 1% within 100 days of the first rate cut. Part of the explanation lies in how aggressively markets had positioned for cuts before the Fed acted. By September 2024, markets had priced in 10 rate cuts before the end of 2025 — a level of easing that proved wildly optimistic. When slowing economic conditions fell short of these extreme expectations, bonds sold off sharply.
Markets Priced In 10 Rate Cuts Before the Fed Cut Once
Why This Time Could Be Different (Or the Same as History)
While the market’s reaction last September was far from ordinary, this most recent rate cut could be less interesting, at least relative to history. Now, markets have priced in, in our view, a more realistic rate-cutting campaign through 2026. Currently, markets have priced in two more rate cuts this year and then roughly 2.5 cuts in 2026. If market expectations are realized, the fed funds rate will end 2026 around 3% (upper bound). Absent a recession and with inflationary pressures still above the Fed’s 2% target, a 3% fed funds rate is much more realistic – albeit on the low end of our expectations – than what was priced in to start the rate-cutting campaign last year. For the fed funds rate to get much lower than what is priced in, the economy would likely need to contract (not our base case), or inflationary pressures would need to fall back to around 2% by year-end 2026 (also not our base case). So, with current market pricing and a 10-year yield trading around 4.15%, we think a 4.0% to 4.5% range is appropriate throughout 2025. In other words, we don’t think we’re in for another historically defying sell off in the rates market post Fed rate cut. No guarantees, of course.
Lawrence Gillum, CFA, guides the fixed income view for LPL Financial Research and has over 20 years of investing experience.
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