Source: Kevin Strategy Research
At the December FOMC meeting concluded in the early hours of today Beijing time, the Federal Reserve cut interest rates by 25 basis points as expected, lowering the benchmark rate to 3.5~3.75%, in line with market expectations. Prior to the meeting, the implied probability of a December rate cut derived from CME interest rate futures was already close to 90%.
This rate cut may represent one of the most conflicted meetings for both the Federal Reserve and the markets: On the one hand, the government shutdown deprived the Fed of two months’ worth of data, akin to “driving in fog.” On the other hand, the Fed faced particularly heightened internal and external disagreements and opposition (with three dissenting votes at this meeting, the highest since 2019), not to mention that the new Federal Reserve Chair is about to be nominated. Therefore, compared to the rate cut itself, the market is more concerned about the future path of rate cuts.
In this context, the tone of this meeting was neutral but slightly hawkish, as evidenced by:
1) Although the Fed cut rates by 25 basis points as expected, the updated 'dot plot' maintained the forecast of only one rate cut in 2026,
2) Powell indicated that the threshold for further rate cuts has been raised, hinting at a possible pause in rate cuts. This statement added wording indicating consideration of the 'extent and timing' of future rate cuts—a phrase last seen in December 2024 when the Fed subsequently halted rate cuts.
3) At the press conference, Powell stated that the current interest rate is essentially at a 'neutral level.'
However, compared to the highly debated yet expected rate cut, more significant events than the December rate cut include: first, the Fed’s decision to begin balance sheet expansion (purchasing short-term bonds to maintain ample reserve assets, with purchases of $40 billion in the first month and high levels sustained in subsequent months), which came earlier than the market anticipated; second, how the nomination of the new Fed Chair will influence next year's rate cut path.
Thus, overall, the market reaction after the meeting was positive but limited in magnitude, with U.S. Treasury yields and the dollar retreating slightly while U.S. stocks, especially the Dow Jones, rose.
Chart: The implied probability of a December rate cut from CME interest rate futures prior to the meeting was 87.6%.
Chart: Post-meeting CME interest rate futures predict two rate cuts in 2026.
Core information of the December rate cut: A 25-basis-point rate cut as expected, signaling a potential pause in rate cuts, with the dot plot maintaining one rate cut in 2026.
The 25-basis-point rate cut lowered the benchmark interest rate to 3.5%-3.75%, in line with market expectations.
Following an unexpectedly hawkish rate cut at the October FOMC meeting, market expectations for further cuts wavered. However, since late November, dovish signals from Fed Governor Waller and San Francisco Fed President Daly, combined with a 32,000 decline in ADP employment in November—the largest drop since March 2023—reignited expectations for a December rate cut. The implied probability of a December rate cut according to CME interest rate futures had reached 87.6% before the meeting, making the rate cut largely in line with market expectations and consistent with our earlier projection that a December cut was 'both possible and necessary.'
Signals suggest a slower pace of rate cuts, leaning more hawkish than anticipated.
While the current rate cut was fully anticipated, the Federal Reserve conveyed a relatively hawkish signal regarding future rate-cutting pace, hinting at a potential slowdown or even pause in rate cuts. In the statement released after the meeting, the Fed added language to consider the 'extent and timing' of future cuts ('extent and timing'), a phrase last seen in December 2024, when the Fed subsequently halted rate cuts. Powell also noted during the press conference that the threshold for rate cuts has been raised, with current rates already near a 'neutral level,' necessitating closer attention to economic data.
The 'dot plot' maintains one rate cut in 2026, fewer than the two cuts priced into CME interest rate futures, but internal divisions remain significant.
The 'dot plot' shows one 25-basis-point cut each in 2026 and 2027, with the terminal rate remaining at 3%-3.25%, unchanged from September, but less than the two cuts currently anticipated by the market. At the same time, divisions within the Fed remain pronounced, especially considering that some officials, including the Fed Chair, will change next year, reducing its reference value.
Chart: The 'dot plot' from the December FOMC meeting indicates one more rate cut in 2026.
Slight adjustments were made to the economic forecasts, reflecting a more optimistic outlook on the economy. Compared to September, the economic projections released at this meeting saw only minor changes, with the Fed slightly raising growth expectations and lowering inflation expectations, indicating greater optimism about the economic outlook. The neutral rate remains at 1.0%.
More important than the December rate cut: The Fed's early balance sheet expansion may influence market expectations of the rate-cut path following the nomination of a new Chair.
Compared to the December rate cut that has already been fully priced in and is unlikely to have a lasting impact, more important developments for the future include:
First, the Federal Reserve's decision to expand its balance sheet, which came earlier than expected and directly benefits market liquidity;
Second, the nomination of a new chair, who will not take office until June of next year. Although the new chair will not be able to completely dominate policy decisions, the market can adjust its trading expectations regarding the interest rate cut trajectory based on the incoming chair’s stance, thereby influencing both financial markets and the real economy through changes in market interest rates.
I. The Federal Reserve's early initiation of balance sheet expansion benefits market liquidity
The Federal Reserve's decision to initiate balance sheet expansion (RMP) came earlier than the market anticipated. It decided to purchase $40 billion worth of short- to medium-term Treasury bonds (with maturities of less than three years) in the first month, followed by several months of high-level purchases, after which the pace may slow down.
Unlike Quantitative Easing (QE), which primarily involves purchasing long-term Treasury bonds (such as those with maturities exceeding 10 years), balance sheet expansion mainly focuses on buying short-term debt to provide liquidity to financial markets. For example, in 2019, the Fed expanded its balance sheet by purchasing short-term Treasury bills (Treasury bills) with maturities of less than one year. While QE predominantly affects long-term financing costs for businesses and households, balance sheet expansion more directly improves liquidity and boosts risk appetite.
On December 1st, the Federal Reserve ended its balance sheet reduction process, and with the U.S. government resuming normal operations and expenditures, the Treasury General Account (TGA) balance declined, alleviating some liquidity pressures. However, the situation has not yet fully normalized. The proportion of reserves in bank assets has dropped to 11.8%, below the threshold that indicates an adequate level of liquidity. The spread between SOFR and OIS widened after July but has eased since late November, although it remains at relatively elevated levels. Therefore, under these circumstances, the Federal Reserve’s resumption of balance sheet expansion will help release additional liquidity, benefiting financial markets and U.S. equities more directly while having limited impact on long-term bond yields.
Based on the speed of balance sheet expansion and TGA declines, we estimate that overall financial liquidity in the U.S. (Fed balance sheet - TGA - reverse repo, approximately equal to commercial bank reserves) will expand by around 10-15% by 2026. In an optimistic scenario, it could return to the level prior to the start of balance sheet reduction in 2022. Historically, financial liquidity shows a strong positive correlation with U.S. equities, providing direct support to the stock market, and exhibits a slight negative correlation with the U.S. dollar and Treasury yields, though the latter is not particularly significant.
Chart: The spread between SOFR and OIS widened after July, eased somewhat since late November, but remains at elevated levels
Chart: The current reserve-to-bank-assets ratio has fallen to 11.8%, below the threshold for transitioning from excessive to moderate abundance.
Chart: Current reserve balances as a percentage of GDP have fallen to 9.4%
Chart: Looking ahead, the direction of U.S. financial liquidity expansion is highly certain.
Two, after the nomination of the new Federal Reserve Chair, expectations regarding the rate cut path may gradually begin to influence market sentiment.
As for the future trajectory of rate cuts, if we follow the guidance from this meeting, it is highly unlikely that further rate cuts will occur.
However, this meeting coincides with a critical juncture when the new Federal Reserve Chair is about to be nominated; hence, this guidance might be viewed by the market as having limited 'validity.' Although the official assumption of office will not take place until June of next year, and complete dominance within the Fed is impossible, once the new chair is nominated, the market can begin trading based on their statements about a potentially 'updated' rate cut path, thereby influencing both markets and the real economy through changes in market interest rates. Therefore, the short-term outlook for future rate cuts appears dependent on economic data — such as the November non-farm payroll (to be released in December) and CPI figures next week, as well as the December data due in January. In the medium term, however, the focus will be on the new Fed chair’s statements and the central bank’s independence.
On December 2, Trump announced that he would reveal his nominee for the new Federal Reserve Chair in early 2026 and hinted that Hassett was a 'potential candidate for the position.' According to Polymarket data, betting markets assign a 73% probability to Hassett becoming the next Federal Reserve Chair, significantly higher than other potential candidates.
Based on currently available information, Hassett appears more dovish than existing Fed officials but seems somewhat restrained, which could lead to deeper rate cuts without entirely undermining the Fed's independence.
On one hand, Hassett has publicly expressed a desire to achieve 'much lower rates over the long run,' suggesting there is 'plenty of room' for rate cuts. On the other hand, he has shown restraint, stating that the Fed Chair’s role must be 'very responsive to data' and affirming that he would not succumb to political pressure to cut rates.
Therefore, we believe that if Hassett assumes the role of Chair, it might result in more rate cuts than the 1-2 indicated by the dot plot and CME interest rate futures, but not to the exaggerated extent of 7-8 cuts advocated by Miran, which would compromise the Fed's independence. Moreover, it would be challenging for the new Chair to dominate completely, so under the baseline scenario, the Fed’s independence would not be entirely lost.
In terms of timing, market expectations will begin to shift gradually in the first quarter following the appointment of the new Chair.
From a timeline perspective, Trump will announce the nomination of the new Chair in early 2026. For Hassett, the process involves first being nominated as a Fed Governor and confirmed by the Senate, then nominated as Chair and confirmed again, before officially assuming the role after Powell’s term ends in May 2026, with the earliest opportunity to preside over the June FOMC meeting. The first quarter of next year will be a critical period following the new Chair’s nomination, during which expectations for rate cuts may resurface, paving the way for another rate cut after the new Chair leads the June FOMC meeting.
Chart: A large drop currently shows the betting market assigns a 73% probability to Kevin Hassett becoming the next Federal Reserve Chair.
Chart: Among the current candidates for the new chair, Hassett’s monetary policy stance leans dovish but still advocates for cautious rate cuts.
We have consistently emphasized that the Federal Reserve should and can cut interest rates.
Regarding whether the Federal Reserve can cut interest rates, we have been more optimistic than the market, repeatedly stressing that the Federal Reserve needs to and can cut interest rates. The reasons are as follows:
1) Current U.S. interest rates remain relatively high, with excessive financing costs suppressing traditional demand, thus necessitating rate cuts.
2) U.S. inflation is expected to gradually peak in the first and second quarters of next year, with the baseline scenario posing no significant obstacle to rate cuts.
3) But not by much; under the baseline scenario, reducing it 2-3 more times could bring financing costs in line withReturn on Investmentthe benchmark.
It is important to emphasize that 2-3 rate cuts represent the neutral level required for the Federal Reserve to address high interest rates. If there are more than three cuts, the U.S. economy and markets may face overheating risks; fewer than two cuts would fail to effectively stimulate economic and housing market recovery.
Chart: Since November 2024, the household mortgage interest rate has remained above the rental yield until it fell again after the September rate cut
Chart: The effective interest rate for commercial and industrial loans on the corporate side remains higher than in all industries except information technology.Return on Investment
Chart: We expect U.S. CPI year-over-year to fall from 3.1% to 3.0% in Q1 next year, while core CPI year-over-year will remain at 3.3%.
Chart: The current gap between U.S. real interest rates and the natural rate of interest is 80 basis points. An additional 2-3 rate cuts could balance financing costs with return on investment.
Asset implications? Balance sheet expansion will further enhance market liquidity. Rate cut expectations are largely priced in, awaiting data and the nomination of a new chair.
In the short term, rate cuts have been largely priced in, and expectations of a pause in future rate cuts before the nomination of a new Fed chair may limit movements in U.S. Treasuries and the dollar. However, balance sheet expansion is expected to directly provide liquidity, benefiting U.S. equities and short-term bonds more significantly.
Looking ahead, focus in the near term will be on next week’s non-farm payrolls and CPI data, as well as January’s economic figures. Attention will also be on whether the Bank of Japan’s rate hike next week (December 19) creates any disruptions. Absent any disturbances, expectations for monetary easing are likely to return early next year after the nomination of a new Fed chair. As we have noted, the strengthening of easing expectations in the short term is not “a sure thing,” but over the medium term, a shift toward easing appears more certain (with the nomination of a new Fed chair early next year and the Fed’s balance sheet expansion). Of course, an overly dovish new chair could backfire.
The current ranking of rate cut expectations priced into various assets is as follows: interest rate futures (2 cuts) > gold and dot plot (1 cut) > copper and S&P 500 (0.8 cuts) > Dow Jones (0.5 cuts) > U.S. Treasuries (0.3 cuts) > Nasdaq (0.2 cuts). This implies that most assets are pricing in a more hawkish stance than the Fed’s dot plot, especially the Nasdaq and U.S. Treasuries, which could see larger rebounds if rate cut expectations return.
Chart: The current ranking of rate cut expectations priced into various assets is as follows: interest rate futures (2 cuts) > gold and dot plot (1 cut) > copper and S&P 500 (0.8 cuts) > Dow Jones (0.5 cuts) > U.S. Treasuries (0.3 cuts) > Nasdaq (0.2 cuts).
► U.S. Equities: The downside is high valuations, but liquidity expansion and earnings recovery continue to provide support, leaving room for long-term growth. Under our base case scenario, we estimate earnings growth of 12-14% by 2026, with valuation expanding slightly to 23-24x, corresponding to an S&P target of 7600-7800. If the market corrects excessively, we suggest buying back.
Chart: Earnings growth is projected at 12-14% by 2026, with valuation expanding slightly to 23-24x, corresponding to an S&P target of 7600-7800.
► Hong Kong and Mainland China Equities: Hong Kong stocks are more sensitive to external liquidity compared to A-shares, particularly for growth-oriented styles that exhibit significant correlation with U.S. equities. Liquidity transmission from balance sheet expansion does not translate as quickly into denominator effects as direct rate cuts would.
► U.S. Treasuries: Short-term bonds benefit from the Fed’s balance sheet expansion, serving as better cash management tools. Long-term Treasuries present trading opportunities, as rates are unlikely to rise further. If the nomination of a new Fed chair turns out to be more dovish than market expectations, yields could fall rapidly. However, whether due to excessive declines leading to economic and inflation recovery or concerns about the Fed’s independence, yields are unlikely to decline significantly thereafter. Therefore, caution is warranted.
Chart: If the Fed cuts rates 2-3 times, we estimate the 10-year Treasury yield will stabilize at 3.8-4%.
Chart: If the new chair is unexpectedly dovish, short-term expectations may push the 10-year Treasury yield down to 3.6%.
US Dollar: It may weaken in the short term due to dovish views from the new Federal Reserve Chair, but as long as it does not significantly compromise its independence, the fundamental recovery narrative will remain dominant, thereby supporting a rebound and strengthening of the dollar.
Chart: Our estimates suggest the US dollar will not weaken significantly by 2026.
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