The Federal Funds Rate (in red on the chart below) tends to follow the US 2-year yield (in black) with a lag. The 2-year yield peaked in October 2023 at 5.2% and then declined sharply to 4.3% by year-end. This 90-basis point decline in yield drove a ferocious rally in stocks and bonds of all types and durations in November and December.

Where to next for Fed policy and short-term interest rates? A further decline in yields may add fuel to the stock and bond rally in the short term. However, as readers examine the chart below, you will recognise that prior peaks in rates (1994, 2000, 2007) have also coincided with weak subsequent periods for stock markets, economic growth and sometimes, outright recessions during past cycles.

This is not the forecast this time around, however. The United States remains the global growth driver and the US economy continues to experience very healthy economic growth, record low unemployment rates and inflation that is trending back towards its long-term mean. CPI inflation in the US is on track to finish 2023 below 3.5% and it is expected that US inflation will continue to moderate in 2024, albeit slowly and end the year in the 2.5%-3.0% range. Jerome Powell’s 2% inflation target will likely become a floor rather than a ceiling in future years.

With healthy GDP growth and inflation near 3%, US interest rates will remain elevated relative to history. It’s likely that the bond bull market that began in 1981 with 15% interest rates, ended in 2022. If US CPI rates settle in the 2.5%-3.0% range, and US real interest rates average 2.0% (slightly above the current real rate on 10-year TIPS), this suggests 4.5%-5.0% as a reasonable expectation for US 10-year yields over the next cycle. Today, US 10-year yields are 3.9%.