Fed's December Rate Cut: Navigating Unemployment and Market Expectations

Recent remarks from Federal Reserve officials, often referred to as "Fedspeak," suggest a growing willingness to implement another rate cut in December. This perspective gained further traction with Friday’s jobs report, which showed the unemployment rate ticking up to 4.2%. This shift not only strengthens the case for easing monetary policy but also limits the potential for a significant rise in bond yields. Consequently, the Treasury yield curve, spanning 2-year to 30-year maturities, is expected to close the year within a favorable range of 4% to 4.5%.

US Job seekers queue at a job fair

Yields and Market Dynamics

Bond yields have eased as markets increasingly factor in a December rate cut. Swaps now imply an over 84.6% probability of this outcome, as highlighted. The upcoming Consumer Price Index (CPI) report will be a critical data point, serving as the final indicator to cement expectations of a Fed move. Despite encouraging headline labor market data, the broader context supports a dovish stance from the Fed. The non-farm payrolls report revealed a robust 227,000 job gain in November, exceeding Bloomberg’s consensus estimate of 220,000. Additionally, upward revisions added 56,000 jobs to the previous two months, boosting the three-month average to 173,000 from 123,000. While these figures reflect a resilient labor market, deeper insights reveal underlying vulnerabilities.

Source: Bloomberg

A Closer Look: Why a Rate Cut is Justifiable

Beneath the surface of strong payroll numbers lies the household survey’s softer data, with unemployment rising to 4.2%. This uptick signals sufficient slack to warrant action by the Fed, particularly as it aims for a soft landing. Policymakers may view this increase in unemployment as justification to proceed with a rate cut, despite the overall stability in the labor market.

The Fed’s dual mandate—promoting maximum employment and ensuring price stability—requires a nuanced approach. Inflation data from the CPI report will be critical in affirming the need for a rate cut, while the dot plot accompanying the next Federal Open Market Committee (FOMC) statement will provide further guidance on the Fed’s forward outlook.

The Role of CPI and the Dot Plot

The upcoming CPI report is expected to play a decisive role in solidifying market expectations. However, even a surprise in the inflation figures is unlikely to disrupt the current market trajectory significantly. With markets already pricing in just three additional rate cuts over eight FOMC meetings in 2025, any adjustments to the dot plot or inflation data are unlikely to trigger sharp movements in yields.

Positioning Amid Yield Curve Dynamics

For now, the yield curve’s range of 4% to 4.5% offers a favorable environment for investors. This equilibrium reflects a delicate balance between growth concerns and inflation risks, aligning with the Fed’s strategy to guide the economy toward a soft landing. Notably, the yield spread between the benchmark U.S. 2-year and 10-year Treasuries has widened in three of the past four days, signaling a return of confidence in steepener trades after earlier inversions.

Market Reactions and Trends in Steepening

Friday’s jobs report provided relief to the bond market, triggering a rally and widening yield spreads. A payrolls figure exceeding 300,000 might have unnerved traders, while a print below 200,000 could have raised concerns about economic weakness. The 227,000 gain struck a balance, seen as a "Goldilocks" outcome—neither too hot nor too cold—that reassured markets.

Momentum-driven Commodity Trading Advisors (CTAs) were active buyers on Friday, responding to the uptick by covering shorts in 10-year futures once prices hit the 111-08 level. Relative value investors also played a role, purchasing long-end cash Treasuries while selling futures. In parallel, mortgage-backed securities (MBS) experienced a surge in demand, as hedging flows further supported Treasury purchases.

Front-End Support and Upcoming Supply

The front end of the yield curve saw significant demand, particularly in January and February Fed fund contracts, as investors bet on more aggressive rate cuts. Additionally, preparations are underway for next week’s $119 billion Treasury supply, which includes $39 billion in 10-year notes and $22 billion in 30-year bonds. This influx is expected to sustain the steepening trend as investors position for the auctions.

Closing Thoughts

As the December FOMC meeting approaches, the Federal Reserve faces a critical juncture in its monetary policy strategy. While headline data may appear too robust to justify further easing, nuanced indicators—such as the rise in unemployment and market expectations for a controlled economic slowdown—bolster the case for another rate cut. With attention shifting to the CPI report and Fed communications, investors should remain vigilant as the year concludes and the bond market adapts to evolving dynamics.