New Fed Call: Hold Me Now

What You Need to Know:

• January's unemployment rate continued to edge lower confirming the recent positive evolution of the U.S jobs market.
• An improving employment outlook should allow the Fed to shift its attention toward the inflation mandate and its anticipated progress for 2026.
• Fed Call Change: We continue to forecast quarterly rate cuts of 25 basis points.
• Expected easing won't be the result of worsening economic conditions, but rather the normalization of policy as inflation gradually returns to its target.
• Treasury yields should continue to move lower throughout the year, but we have revised our year-end forecast for 10-year Treasuries to 3.75% — well below forwards and consensus.
• Structurally, we remain comfortable with our core bearish USD view. Risk-reward should still favor USD downside over the coming quarters.
• U.S. resilience is likely to fall short of U.S. exceptionalism, which in a backdrop of solid global growth, lower rates and fiscal buffers is positive for risky assets and is bearish for the dollar.

Fed to Stay on Hold for Longer

We expect the Federal Reserve to stay on the sidelines for longer amid a resilient backdrop for economic activity and a stabilizing labor market as we start 2026. The U.S. January employment report confirmed the recent positive evolution of the jobs market, with the unemployment rate edging lower for a second consecutive report after hitting 4.5% in November.

Labor market conditions have been the most pressing factor under the Fed's reaction function in recent meetings, and an improving employment outlook should allow the Fed to shift its attention toward the inflation mandate and its anticipated progress for 2026.

This is a counter to last summer when worsening employment conditions steered the Federal Open Market Committee (FOMC) to bring its rates closer to neutral. At the time, Fed leadership felt the policy stance was too restrictive when judged against the ongoing deterioration in labor demand.

After 75bps of easing in 2025, the Committee feels that policy is now better placed to respond to an adverse evolution of its dual mandate. This means that the onus will be on the data to force the Fed's hand in 2026. We expect that next lever to be clear inflation progress towards the 2% objective.

While we still project another 75bps of rate cuts in 2026, we now look for easing to be implemented in the back half of the year (versus starting in March). We continue to forecast quarterly rate cuts of 25 basis points in June, September and December, bringing the Fed funds rate to our projected terminal of 3.0%. Expected easing won't be the result of worsening economic conditions, but rather the normalization of policy as inflation gradually returns to its target.

Our new Fed policy path hinges on two key assumptions:

• A labor market that steadily stabilizes, with the unemployment rate gradually declining to 4.2% by the end of 2026. This would fall well within the Fed's central tendency of the longer run unemployment rate projections.
• Underlying inflation that continues to provide signs of progress, particularly the m/m evolution of core Personal Consumption Expenditures (PCE) prices. We look for the monthly path to be running close to 0.2% m/m on average (Mar-May) by the time of the June FOMC meeting.

Risks to Our Fed View

If the above assumptions fail to materialize, we expect the Committee to formulate different policy prescriptions for 2026:

• Hawkish, if inflation proves sticky amid a healthy labor market; or
• Dovish, if employment conditions suddenly deteriorate.

The Fed's response will be asymmetric in favor of more cuts. A dovish outcome would see the Fed easing much more than we're currently anticipating, while a hawkish scenario will see the Committee pausing through 2026. We still judge the bar to be high for the implementation of rate hikes, especially amid the direction of likely new Fed Chair Warsh that will espouse a decisive dovish bias.

The UE Rate Declined in December After Moving Steadily Higher Since June

Rates Implications

With the Fed on the sidelines for longer as they assess the macro fundamental outlook for the economy, we make a number of adjustments to our interest rate forecasts. The key changes to our forecast are outlined below:

Upgrading year-end 10-year forecast to 3.75%

We still expect rates to fall this year as we expect economic momentum to remain steady, Treasury supply dynamics to become less of a headwind and underlying demand for Treasuries to remain solid. In the near-term, however, we expect 10-year rates to trade in the 4.10-4.30% area as markets wait for more information on the health of the economy. Note that data surprises have tended to be quite positive through mid-Q1 but have subsequently turned lower, which can help pressure Treasury yields lower in the next several months. Our year-end forecast is below both forwards (4.40%) and consensus (4.15%).

Curve should be near peak steepness and flatten gradually

Concerns around Fed independence, Treasury supply and foreign demand may continue to weigh on investor sentiment. However, we believe the 2s5s and 2s10s curves are already reflecting the macro pricing for the cycle. As such, we're positioned for 2s10s curve flattening in our model portfolio.

Long-end rates remain a concern

Despite our expectation for better performance in the 7-10 year sector, the long-end remains vulnerable, and 20s and 30s may continue to lag the move lower in yields. Treasury recently suggested that they are re-evaluating issuance, which we believe may involve trimming the size of 20-year and 30-year issues in the future. That said, Treasury may wait until more significant pressure builds on the long end before taking such a measure.

U.S. Economic Data Tends to Show Positive Residual Seasonality Early in the Year Before Weakening

FX Implications

We expect the change in our Fed path to have a limited impact on our FX views for further USD weakness. Our outlook is based on:

• a pro-cyclical risk backdrop globally which puts us in the middle of the USD smile and a bearish USD environment and
• a continuation of the structural hedge America and hedge USD trade with the dollar struggling to behave like a safe haven.

The fluctuations in the Fed path and pricing do matter for FX, but to a lesser degree than usual given the focus on geopolitical risks and change in perception of the dollar as a safe haven.

We are tactically bullish on the USD as U.S. data tends to be strong in January and February. But structurally, we remain comfortable with our core bearish USD view. Risk-reward should still favor USD downside over the coming quarters from strained haven status, and continued hedge America trade.