Michael Metcalfe
Head of Macro Strategy,
State Street Global Markets

Initial reaction to the Fed’s rate cut suggests that this is potentially good news for financial markets, especially in the United States. However, our array of market intelligence on risk, investor behavior, inflation and media sentiment may suggest otherwise.

Significant macro uncertainties remain around the resting point of inflation, the steady state of short-term interest rates and the sustainability of fiscal policy. Any one of these factors could trigger a need to re-assess risk premia for all asset classes – something that investors may not be taking into account.

All of this points to the need for more careful diversification across assets and geographies in the coming years. In this article we outline what we’ve learned from market reactions and State Street’s proprietary data to help you understand why.

Lesson 1: The balance of risk has finally shifted, but uncertainty has not

Fed Chair Jerome Powell – and ultimately the committee’s relatively rapid pivot – owes much to the shift in the balance of risk. At State Street, we track inflation moves in real time through our exclusive partnership with PriceStats, which scrapes data every night from hundreds of retailer websites spanning millions of products. These indicators, which are followed by many of our clients as well as the Fed, have tended to lead shifts in the consumer price index (CPI). The inflation trend has been volatile this year, but PriceStats’ online data has been benign for months, with the annual inflation rate dipping below 2 percent once again in early August (see Figure 2).

This is similar to the trend in official data, excluding shelter, as discussed by State Street Associates academic partner and PriceStats co-founder, Alberto Cavallo, in our recent Street Signals podcast. It was also highlighted by Chair Powell in the Federal Open Market Committee (FOMC) press conference when he pointed out that the stickiness of inflation in rents is partly related to structural issues with the housing market, as well as the level of rates themselves.

In short, inflation data has been benign for long enough to give the Fed comfort that the risks around inflation are now balanced with upside risks still emanating from housing and selected service sector inflation, and downside risks from the goods sector and supply side once again.

At the same time, and crucially for the pace of easing that will now come, the risks around the full employment mandate have also shifted.

Unemployment has risen quickly in recent months, the level of job openings are back to within 10 percent of pre-pandemic levels, and wage growth has been relatively static. The picture is complicated by consistent and large downward revisions to payrolls growth. Alternative data sets such as Indeed’s Hiring Lab, which tracks activity across millions of job postings around the world, are consistent with a gradual normalization in conditions rather than a dramatic collapse. Nevertheless, we can anticipate a continuation of significant swings in financial asset market pricing if and when there are further surprises in US employment data in either direction.

The fact that the Fed’s own projections have the unemployment rate falling back to 4 percent over the next three years shows there is plenty of room for surprises. The same is true, meanwhile, on any upside surprises on inflation, which is forecast to fall back to 2 percent – while growth in inflation is expected to remain at trend.

Lesson 2: Reaction to the Fed cut suggests interest rate markets got ahead of themselves, but a closer look at positioning suggests otherwise

Equities reacted well to the bigger-than-expected rate cut, but the fixed income market reaction so far has been more interesting. It is not unprecedented for US two-year yields to rise after a 50 basis points interest rate reduction, but it is unusual. This is also a reminder that as bold as the Fed’s move was, it remains behind the curve implied by interest rate markets.

Throughout this cycle, interest rate markets have veered from being too pessimistic on eventual rate outcomes, to being too optimistic (see Figure 2). For now, they remain firmly in the optimistic camp. This implies that interest rate markets (as indicated on the chart by the Dec ’25 fed funds futures) are expecting lower official interest rates than the Fed’s projections (as indicated by the FOMC ’25 median dot).

There is potential good news from our measures of investor behavior, too: Our aggregated and anonymized flow and positioning indicators for Treasuries, derived from State Street’s US$44.3 trillion in assets under custody and administration,^* reveal that real money investors have room to add to their Treasury holdings.

As we highlighted in July, long-term investor holdings of Treasuries were close to neutral and they remained so at the beginning of September. Given the rapidly growing funding ask from the US Treasury and weakening or reversing demand from less price-sensitive buyers explored in depth in our latest paper, this is potentially welcome news. Ten year US Treasuries are not over-owned by long-term investors, so if the labor market were to deteriorate further and the Fed moved faster on cutting interest rates, there would be a significant set of investors that may be ready to buy duration.

Lesson 3: Asset allocation trends remain stretched in favor of equities

Taking a broader view across our measures of long-term investor positioning highlights a more medium-term strategic balance of risks. Our monthly Institutional Investor Indicators show that allocations to equities are still more than 25 percent of portfolio weight higher than allocations to fixed income assets (see Figure 3). This is 5 percent higher than the long-run (25-year) average of 20 percent. While this allocation gap in favor of equities was higher in the late 1990s and again in the mid-2000s, it is notable that the gap has shrunk in favor of bonds during each of the three Fed easing cycles in the past quarter of a century.

This insight is reinforced by our work on long-term portfolio construction and discussed in our paper, Co-occurrence: A new perspective on portfolio diversification, which finds that the observed correlation between stocks and bonds since the 1970s are highly regime dependent; specifically, higher inflation regimes are often associated with positive correlations between stocks and bonds, while low inflation regimes are not. With the Fed easing cycles by definition occurring in the latter, we should expect the diversification properties of stocks and bonds to return. In other words, the days of the “everything rally” we have enjoyed at various points this year, may not last.

Lesson 4: Expect growing divergence across geographies and currencies

The summer of 2024 demonstrated that not only could equities and bonds as asset classes provide diversification; divergence across countries is growing as well.

This is a function of a number of factors: First, the rise in political risk, which by definition runs along country lines. Second, global growth and inflation is becoming much less correlated across economies, which is reflected in increasingly divergent monetary policy cycles. While the Fed has just begun its easing cycle, the Bank of Japan is just at the beginning of raising rates to more normal levels. However, some emerging market economies are also on the brink of resuming tightening, having been through easing cycles more than a year before the Fed.

This lack of synchronization is leading to wider divergences in asset performance for different countries, as well as significant currency misalignments in places.

Our metrics of investor behavior show that long-term investors are already positioned for some of these divergences across equity regions (see Figure 4).

As indicated in the chart, investors began 2024 with a significant overweight in the US equities relative to the rest of the world, and emerging markets in particular. Nine months later, holdings of US equities are even higher, as investors have also added an underweight in European stocks. These divergences will potentially represent opportunities in 2025 should anything dent investor confidence in US outperformance.

As rates normalize, both upwards and downwards, and disinflation unfolds at various speeds across the globe, growing interest rate differentials are expected to drive currency volatility too, along with the importance of foreign exchange (FX) carry strategies. These strategies were rendered ineffective in the summer during a volatility surge.

What are the long-term implications?

September has demonstrated the “Fed put” is firmly in place as the increasingly dovish tone of Chair Powell indicates. The market’s preliminary reaction is that this is good news for US equities, but it was still a modest disappointment for bond markets given elevated expectations for an easing cycle. We would, however, be wary of extrapolating these moves into 2025.

Long-term investor allocation to equities relative to bonds are already stretched in favor of equities. In lower inflation regimes, which we remain in for now, and during Fed easing cycles, which we have just begun, we note that allocations to bonds typically go up relative to equities, as they provide more reliable diversification benefits. Given that growth and policy cycles are showing increasing signs of divergence, it also seems likely that country and currency risk will provide further diversification opportunities. This indicates that the current tendency to be significantly overweight US equities may be vulnerable.