The Fed and the ECB are in a good position to wait and see

What are the key takeaways from the market news on December 12, 2025?  Xavier Chapard provides some insights.

Going further

Fed: No more patience, lots of disagreement, but a downward bias maintained

The Fed cuts interest rates for the third consecutive meeting

As expected, the Fed cut its key rate by 25 basis points to 3.5/3.75%. This is the third consecutive cut after a nine-month pause, meaning that the Fed will have cut rates by 75 basis points this year after 100 basis points in 2024. 

The Fed is adopting a slightly less accommodative tone, also as expected. The rate adjustment to “manage risks” is nearing its end and a pause is likely in January.  Indeed, the Fed members' rate projections (the famous “dot plot”) remain broadly unchanged and indicate only one rate cut in 2026 and 2027, which is a slower and more limited pace of rate cuts than in the previous two years. Furthermore, the Fed adds in its statement that it will decide on the “extent and timing” of any further adjustments. It last used this wording in December, before taking a long pause in its rate cuts. This suggests that the conditions for further rate cuts are more stringent than in recent months. Finally, Powell indicated during his press conference that the Fed was “in a good position” to wait and see, now that it had brought its rates back into the range of neutral rate estimates (i.e., the rate that neither accelerates nor slows the economy and inflation). This suggests that the mid-cycle adjustment is well underway.

But overall, the Fed maintains a bearish bias. In its statement, the Fed reiterates that inflation remains “somewhat elevated” and that “the unemployment rate has risen slightly,” which is balanced. But it specifically notes that it “believes that downside risks to employment have increased in recent months.” And there is no longer any mention of the fact that the unemployment rate remains “low.” This suggests that the majority of Fed members still believe that the risks to employment outweigh the risks to inflation at the end of the year, implying a bias toward further rate cuts. The dot plot also shows that no member anticipates a rate hike next year, while the majority anticipate one or more cuts and the current rate is at the high end of the neutral rate estimate range. During the press conference, Powell reinforced this accommodative sentiment by indicating that employment had probably been overestimated in recent months and that, in reality, it had probably fallen slightly since the summer. Powell also anticipates that the temporary impact of tariffs on inflation will begin to subside after the first quarter. 

Overall, we are maintaining our scenario of a final rate cut in March and believe that the risks surrounding this scenario are balanced at present. However, the flood of macroeconomic data coming in next week following the end of the shutdown could change this balance.

Fed members still only signaling one rate cut for next year

Beyond the expected message from the Fed, what is surprising is the very high level of disagreement within the Fed. Three of the 12 voting members voted against the decision to cut rates by 25bp, a first since Covid. Once again, opposition came from both sides. Miran, a Trump ally whose term ends in January, once again voted for a larger cut (50bp). Conversely, two regional Fed governors voted to keep rates unchanged, one more than in October. And six members of the monetary policy committee indicated in their projections that they wanted rates to remain unchanged in December, suggesting that several other regional Fed governors would have voted against this week's rate cut if they had been eligible to vote this year.

Has Powell lost control of Fed policy? This would not be surprising with less than six months left in his term and given the current political pressures. Above all, there is significant uncertainty about the balance of risks between employment and inflation in the coming months. This does not promote consensus.

These internal tensions are somewhat muddying the Fed's message and increasing uncertainty about what the Fed will do under the next chair starting in the middle of next year. This could ultimately inject more volatility into the long end of the US yield curve.

The Fed members' scenario is less stagflationary 
 

For the markets, we believe the Fed's stance remains positive, which supports our overweight position in equities for the start of next year. 
Indeed, even if the Fed is unlikely to cut rates much further in the middle of the cycle (only once, in our view), the fact that it is maintaining a dovish bias is a key source of reassurance for risky assets. This implies that it will support the markets in the event of any negative surprises. And the market is now only pricing in one rate cut between now and mid-2026. This limits the risk of disappointment in the short term, even if we believe the market's expectations for rate cuts beyond that point are still a little too high. 
Finally, the Fed's new scenario is fairly optimistic, which should support investor confidence. Fed members have significantly revised growth upwards for the coming years (by 0.7% cumulatively by 2028) while revising inflation slightly downwards for next year. The Fed therefore anticipates less stagflationary conditions than previously.

Fed: Balance sheet policy reduces risk of tension in money markets

The Fed will start increasing its balance sheet again today

At Wednesday's Fed meeting, the Fed announced that it would resume increasing its balance sheet today, just days after stopping its reduction. This was taken by the markets as a sign of further easing (the return of quantitative easing?). 

In reality, this is a technical adjustment that the Fed is making to manage liquidity. Bank reserves deposited with the Fed have fallen sharply since September because, in addition to the balance sheet reduction (quantitative tightening or QT), the Treasury's current account at the Fed has grown rapidly due to the shutdown. As a result, bank reserves have returned from an excess level to an “ample” level, which was the Fed's objective.

The Fed wants to avoid tensions in the money market

The right level of reserves for the Fed is the lowest level that allows market interest rates to remain within its target range (currently 3.5-3.75%). However, slight tensions on interest rates have emerged since October, despite bank reserves still being close to $2.9 trillion. In fact, overnight repo rates and interbank rates have risen to the upper end of the Fed funds rate target range and have even exceeded the upper limit on some days. This is a sign that some financial institutions were having some difficulty accessing the liquidity they needed.

The Fed therefore believes that the time has come to gradually increase bank reserves to avoid any liquidity stress. 

The Fed will be the largest buyer of Treasury bonds next year

To do this, the Fed will start increasing its Treasury bond portfolio again. In addition to replacing maturing mortgages (RMBS purchased during QE), it surprised everyone by announcing that it would also purchase $40 billion of Treasury bonds per month over the coming months to increase its balance sheet. This is probably a catch-up period to ease money markets. Starting in the second quarter, it should slow its pace of purchases slightly to increase its balance sheet at a more gradual pace.

But ultimately, the Fed will probably buy more than $500 billion in Treasury bonds in 2026. This is not quantitative easing and should not have a direct impact on US rates, as the Fed is only buying very short-term securities. But it will facilitate the financing of the US public deficit, which will be done largely through the issuance of Treasury bills rather than longer-term bonds. Indirectly, this will therefore limit upward pressure on long-term rates. For riskier assets, the increase in liquidity and the decline in the risk of monetary tensions are also indirectly positive factors.

Developed countries: The end of the monetary easing cycle is approaching

Most central banks are not expected to ease their rates further by mid-2026.

After two years of key interest rate cuts in almost all developed countries, the end of the monetary easing cycle is approaching. In addition to the Fed's greater caution, the ECB has been on hold since July and the last rate cut, expected in early 2026, seems increasingly unlikely. This week, the Swiss National Bank kept its rates unchanged at 0% and suggested that it would only cut them further in the event of a negative surprise. The Bank of Australia has even announced a shift in policy, saying it could raise rates as early as early 2026. And the Bank of Japan is expected to raise rates next week. That said, the cycle of rate cuts is not yet completely over, as the Bank of England is likely to confirm next week by continuing its rate cuts.

Overall, the easing cycle is likely to end in mid-2026, when more central banks will be considering rate hikes rather than cuts. The average policy rate in developed countries will then have returned to a broadly neutral level after nearly three years of high rates. But if the global economy holds up as we believe it will, it will not shift into accommodative territory, unlike in the pre-Covid decade.

These conditions will be less favorable for risky assets than they have been over the past three years, when valuations benefited from falling interest rates. That said, they will not be unfavorable as long as central banks do not raise their rates. In this context, we remain positive on risky assets at the start of the year but anticipate fairly subdued performances, and are prepared to reduce risk in our portfolios during the year if the shift in monetary policy is more pronounced than expected.

Xavier Chapard

Strategist