The Fed’s biggest decision this week could have nothing to do with interest rates
A third rate cut this year may be a foregone conclusion but any clues about its plans for its balance sheet will be crucial. – Getty Images
The stock market finished on the cusp of record highs on Friday, led higher as the odds of another Federal Reserve rate cut looked like a foregone conclusion.
Yet beyond an expected third Fed rate cut for 2025, the bull run in stocks and other risk assets could be due for a different kind of boost when the Fed wraps up its Dec. 9-10 policy meeting.
“Right now, the interest-rate side of monetary policy is clearly restrictive,” said Michael Kelly, global head of multiasset at PineBridge Investments, a global investment firm with $215.1 billion in assets under management. “But it’s not mattering.”
At least not when looking at the S&P 500 index SPX, which rose to 6,870.40 in the past week, ending only 0.3% off its October record, according to Dow Jones Market Data. It was 16.8% higher on the year through Friday, poised for another stellar year of gains.
In that regard, there have been two U.S. monetary policies at play, in Kelly’s view. There’s balance-sheet monetary policy for the “asset rich” that’s been adding to the “wealth effect,” fueling spending and helping keep the economy afloat— and interest rates for the rest.
Higher rates have taken a toll on small businesses, where layoffs are happening. They’ve also put stress on the bottom-rung of households in the “K-shaped” economy, whereas you can argue there has been an improvement for the upper-rung, Kelly said.
Recent credit-card data tells a similar story. Lower-income consumers more often carry credit-card balances, and risk bumping up against their credit limits, wrote Grace Zwemmer, an associate economist at Oxford Economics, in a Friday note. But “upper-income consumers, who are less likely to carry balances on their credit cards, have been driving consumer spending.”
The two economies make anything the Fed might say about its $6.5 trillion balance sheet crucial for markets, Kelly said. “Are they going to hold it flat or start growing it?”
Despite patches of weakness in a tumultuous year under President Donald Trump’s second term, the stock market looks poised to soon recapture record highs.
This comes during a stunning 73% advance for the S&P 500 over the past three years, according to FactSet.
The boom speaks to enthusiasm over artificial intelligence plays and to how little the Fed’s higher rates have dampened the bullish stock-market sentiment.
Equally important, credit spreads remain near historic lows, signaling little worry by investors about looming defaults.
The favorable backdrop for assets comes as the U.S. central bank already reduced its roughly $9 trillion peak pandemic balance sheet by about $2.5 trillion. It then stopped shrinking it on Dec. 1 after pressures cropped up in overnight funding markets.
That’s important because the Fed has been vocal about wanting to avoid a repeat of the 2019 repo crisis. A rates strategy team at BofA Global on Friday said they expect the Fed next week to announce “reserve management purchases” of Treasury bills that mature in a year or less, starting in January at $45 billion monthly pace.
“We are out of consensus early and in size,” the team led by Mark Cabana wrote, in a client note. That would result in an estimated Fed buying of at least $20 billion a month “for natural balance sheet growth purposes” and another $25 billion a month “to reverse the reserve over drain, for at least the first 6 months,” the team wrote.
Others think it could take more time, and for the Fed to do less to keep markets functioning smoothly.
“If you zoom out, the Fed naturally will start bill purchases next year as part of a reverses management operation,” said Roger Hallam, Vanguard fixed-income group’s global head of rates. “Because as the economy’s demand for reserves expands, the Fed naturally will meet that.”
Hallam expects the Fed to start purchasing Treasury bills at a $15 billion to $20 billion monthly pace around the end of the first quarter, or early in in the second quarter.
“That’s normal central bank reserves operations, there’s not a monetary policy signal within that,” he told MarketWatch. “That’s just the normal course of business for what the Fed should be doing to ensure there’s liquidity in the system.”
“It’s to keep funding rates stable,” Hallam said.
Kelly at PineBridge expects the Fed to cut rates by another 25 basis points on Dec. 10, which would bring its policy rate to a 3.5% to 3.75% range and a step closer to the roughly 3% historical “neutral rate” designed to keep the economy on an even keel.
Still, longer-duration Treasury yields rose sharply in the past week despite the expected looming rate cut. The 10-year yield BX:TMUBMUSD10Y hit 4.14%, signaling that borrowing costs may remain higher for households, businesses and U.S. government even as short-term are lowered.
Kelly said he’s “pretty optimistic about most markets for next year,” even if the central bank were to talk only about starting to grow its balance sheet in the new year to get back to a more “normal liquidity” backdrop.
“I don’t know why the Fed is so eager to grow its balance sheet, but stingy to cut interest rates,” Kelly said. “I would be doing it the other way.”
The Dow Jones Industrial Average DJIA is up 12.7% on the year so far, while the Nasdaq Composite Index COMP is 22.1% higher, but the liquidity-sensitive bitcoin BTCUSD is down 2% in 2025, after plunging into a bear market last month.
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