This year’s Santa rally came with a Fed clause. Markets are recovering, but remain in turmoil after officials at the world’s most powerful central bank turned far more hawkish on the year ahead than almost anyone had expected even as they lowered benchmark interest rates for a third consecutive time. The dollar is trading near a post-2022 peak, ten-year Treasury yields are holding at seven month highs above 4.5 percent, most major equity indices are down more than 3 percent, and the VIX volatility index—Wall Street’s “fear gauge”—is up dramatically after hitting its loftiest levels since the August 7 volatility shock.

As had been widely anticipated, the Federal Reserve cut interest rates by a quarter of a percentage point and signalled that it would likely pause for breath in January. The statement included language that has been used to telegraph an extended hold in the past, and speaking during the post-decision press conference, Jerome Powell said “We have lowered our policy rate by a full percentage point from its peak and our policy stance is now significantly less restrictive. We can therefore be more cautious as we consider further adjustments.”

But stronger-than-expected growth and Donald Trump’s shadow loomed over the “dot plot” summary of economic projections. Officials scaled back their rate cut expectations for 2025 from four to two, and sharply raised inflation projections, with the “central tendency” for the core personal consumption expenditures index jumping from 2.2 percent to 2.6 percent, suggesting that most policymakers expect the president-elect’s policy mix to translate into a slowing in the pace of disinflation. In September, three of 19 committee members thought the risks to their core inflation forecast were weighted to the upside, and yesterday 15 of 19 thought the same. Chair Powell said he expected the central bank would wait to see “what the actual policies are” before making a “careful, thoughtful assessment of what might be the appropriate policy response,” but acknowledged that “Some people did take a very preliminary step and start to incorporate highly conditional estimates of policies into their forecasts at this meeting”.

Currency markets reacted dramatically, with a spike in fed fund futures—which measure market views on the central bank’s policy trajectory—triggering a rally in the dollar against all of its rivals. To some extent, this is now unwinding, but most majors remain on the defensive against a resurgent greenback.

The currency market retracement could gain steam. Fed officials are not contemplating a deliberate tightening in financial conditions—their inflation expectations moved up in line with interest rate estimates, meaning that real rate projections remained unchanged. As we warned in yesterday’s missive, the decision landed within a fragile year-end rebalancing period that is often punctuated by extreme moves. And history suggests that the “dot plot” is rarely accurate in determining how the Fed’s policy path ultimately plays out.

But other risks could roil markets in the days ahead—most obviously, the imminent shutdown of the US government. The federal government is likely to run out of funding by the weekend after a social media campaign led by Elon Musk saw House Republicans ditch a bipartisan continuing resolution aimed at keeping the current budget in place until March. In a statement, Donald Trump and vice president-elect JD Vance said “we should pass a streamlined spending bill that doesn’t give Chuck Schumer and the Democrats everything they want,” noting that they want the bill to include an increase in the debt ceiling so that it happens under “Biden’s watch”. Shutdowns in fiscal 2013, 2018 and 2019 cost the government billions of dollars, subtracted from gross domestic product, and pushed yields higher.

The Japanese yen is sharply weaker after policymakers at the Bank of Japan left rates unchanged and Governor Ueda hinted they could wait several months before hiking rates again. In line with the consensus forecast, the policy board kept its benchmark rate at 0.25 percent, with a single dissent—from Naoki Tamura—in favour of a rise to 0.50 percent. The surprise came during the post-decision press conference, when Kazuo Ueda said officials were awaiting more information on the pace of wage growth—which would presumably come around the conclusion of the spring “shunto” negotiations in late April or May—as well as the impact of Trump’s trade, immigration, and fiscal policies on global financial markets. “Needless to say, [with respect to] both Japan’s wage outlook and the impact of Trump’s policies, [it could] take a long time to grasp the entire picture,” he said, noting that underlying inflation remained “very moderate,” giving the Bank room to move gradually.

The British pound is tumbling after Bank of England officials expressed more support for cutting rates than had been anticipated. The central bank’s Monetary Policy Committee voted by a 6-to-3 margin to leave rates unchanged in the latest decision, with Deputy Governor Dave Ramsden and Alan Taylor joining Swati Dhingra—a long-standing dove—in supporting a rate cut, suggesting that policymakers are inclined to look through recent signs of accelerating price growth as they brace for more economic turmoil. The meeting minutes showed a majority of participants worrying that data released in the last few days “added to the risk of inflation persistence,” but also noted that although “annual private sector regular average weekly earnings growth picked up quite sharply in the three months to October”, it “has tended to be more volatile than other wage indicators”. Growth concerns have intensified as “most indicators of UK near-term activity have declined,” and significant uncertainties are seen ahead: although the minutes don’t name him directly, the global economic risks associated with the US president-elect’s policy changes have “increased materially,” exposing the country to potential negative consequences.

Here in Canada, the loonie is trading near a post-pandemic low. This is generating a lot of hand-wringing among observers, and a lot of narrowly-focused observations about the causes. In our view, there are four proximate reasons for the currency’s underperformance—last decade’s end to the energy supercycle, which decimated investment in Canada’s oil and gas sector, a household sector that became horrifically indebted during the long run-up in real estate prices, a US economy that is outperforming and lifting Fed policy expectations, and Trump’s recent tariff threats. The imposition of 25 percent tariffs could certainly send the economy spiralling into recession next year. But—at the risk of sounding like fanatics*—we think the debt burden is the biggest problem, given that higher carrying costs have crushed household consumption and exacerbated the country’s vulnerability to external shocks. We also see this becoming a modest tailwind, with falling interest rates helping support a gradual recovery in the year ahead.