Risk-On Rally as the Fed Fine-Tunes Policy and Market Leadership Broadens

Executive Summary

Last week, markets leaned risk-on as the Fed delivered its third consecutive rate cut and investors doubled down on the soft-landing narrative. Stocks wavered early but rallied after Wednesday’s Fed decision, with the S&P 500 and Dow moving back toward all-time highs. The Russell 2000 set record highs on consecutive days, and the equal-weight S&P 500 outperformed the broader index as leadership shifted from mega-cap growth to small caps and cyclicals. The Nasdaq and large-cap growth stocks finished the week down, and defensive sectors lagged. In the credit market, bonds ended the week with modest losses as Treasury yields edged higher in anticipation of the Fed pausing its rate-cutting cycle. Oil held near a four-year low, reinforcing the disinflationary tailwind, while gold hovered near record levels and Bitcoin remained volatile.

Key Considerations

1. Labor data continues to show a job market that is solid but cooling. Job growth and hiring are slowing, wage inflation is easing, but there’s no sign of broad-based layoffs. With the shutdown delaying the official jobs report, the Fed and markets are leaning on proxies like ADP payroll data, job openings, and jobless claims. Implication – The soft-landing narrative remains intact, but the lack of timely data is keeping macro uncertainty and event risk elevated.
2. Recent inflation data reinforces the idea of a slow disinflation process. Inflation has fallen from post-pandemic highs, but it remains above the Fed’s 2% target. Surveys highlight persistent price pressure from tariffs and supply-chain shifts, and while oil trades near a 4-year low, its disinflationary pulse could reverse with elevated geopolitical tensions. Implication – The disinflation progress continues, giving the Fed cover to cut in December, but tariff uncertainty and simmering geopolitical tensions mean the disinflation story is fragile.
3. The Fed delivered a widely expected -0.25% rate cut last week, its third in a row. However, it did so in a way that framed the move as fine-tuning rather than the start of a prolonged cutting cycle. The decision was unusually divided with a 9-3 vote, highlighting significant internal dissent, and the Fed forecasted only one cut in 2026. Chair Powell’s commentary highlighted the uncertain outlook, referencing both the soft labor market and mixed inflation data. Implication – The Fed stopped short of calling for a rate hike but also didn’t endorse the market’s forecast for two cuts in 2026. Fed officials believe they’re in the right neighborhood and now want to wait to see what happens.
4. Markets treated the decision as a green light for risk, with equities rallying toward record highs. The more notable story was a broadening in market leadership from mega-cap growth toward small caps and cyclical sectors. Treasury yields declined, led by the front end as Chair Powell pushed back against a potential rate hike, and credit spreads remained tight. Gold remained near its all-time high, signaling concern about the combination of a policy mistake, inflation, and geopolitical tensions, and Bitcoin stabilized but remained volatile. Implication – Market pricing and investor positioning reflect high confidence in a soft landing.
5. JPMorgan described the U.S. consumer as “a bit more fragile,” noting households are feeling the squeeze from higher prices and fading excess savings even though credit metrics remain generally healthy. The message was less about an imminent downturn and more about a consumer whose cushion is thinner than it was a year or two ago. Implication – The consumer is the main engine of U.S. growth, accounting for nearly 70% of economic activity. A slowdown in consumer spending could translate into slower economic growth.
6. This week’s inflation and jobs report take on outsized importance with the Fed on pause and the economic data backlog from the shutdown still clearing. The reports will help answer two key questions: (1) is the labor market simply cooling or starting to weaken more significantly, and (2) is inflation still progressing toward the Fed’s 2% target or stalling in the 3% range. Implication – Markets have traded the story for a few weeks; now they get fresh data to test it against.

Equities

The S&P 500 returned -0.6% for the week. Stocks rose to an all-time high after the Fed delivered the rate cut that the market wanted, and Fed Chair Powell expressed optimism for economic growth in the new year. A weak revenue report from AI bellwether Oracle at the end of the week, however, dragged down AI-related stocks and the index retreated from its high on Friday.  Mid cap (+0.6%) and small cap (+1.2%) stocks maintained some recent momentum during the week. Market breadth appears to be broadening; materials (+2.4%) and financials (+2.3%) were the best performing sectors in the S&P 500; communication services (-3.2%) and technology (-2.3%) were the laggards. EAFE markets returned +0.9% with gains in Japan (+1.4%) and Europe (+0.7%), while EM markets returned +0.4% with gains in Brazil (+1.4%) and Korea (+1.0%) offset by losses in India (-0.9%0 and China (-0.7%).

From a valuation perspective, the S&P 500, NASDAQ and EM trade at or above +1 standard deviation based on historical forward P/E ratios with the S&P 500 at +1.9, NASDAQ at +1.1 and EM at +1.2. For the next 12 months, EPS growth for S&P 500 is expected to be 10.8% (vs. 6.9% annualized over the last 20 years). For the next 12 months, EPS growth for NASDAQ is expected to be 22.1% (vs. 10.7% annualized over the last 20 years). Equities across markets caps in the U.S., and in non-U.S. developed and emerging markets, trade at or above their 20-year averages based on forward P/E ratios.

Fixed Income

Investment grade fixed income sectors had negative returns as rates rose across the curve. Municipals returned +0.0%, US AGG returned -0.2% and US IG returned -0.3%. HY bonds returned -0.1% as spreads widened 11bps while bank loans returned +0.1%. EM debt returned +0.1% even as the U.S. dollar fell 0.6%.

Rates

Rates rose at the long end of the curve. The recession-watch 3M-10Y spread widened 13bps to +56. The 2Y-10Y spread widened 9bps to +66. Rates rose in other developed markets as well. The BTP-Bund spread is at 0.69%. 5-year breakeven inflation expectations fell 2bps to 2.33% (vs. low of 1.88% on Sept 10, 2024); 10-year breakeven inflation expectations rose 1bp to 2.28% (vs. recent low of 2.03% on Sept 10, 2024); the 10Y real yield rose 4bps to 1.89%. For 2026, the market expects between 2 and 3 cuts vs. the Fed’s guidance of 1 cut. At year-end 2025, the market expects the Fed Funds rate to be 3.06% vs. the Fed’s guidance of 3.25%-3.5%.

Currencies/Commodities

The dollar index fell 0.6%. The commodities complex fell 2.9% as energy prices fell 6.4% for the week. Brent prices fell 4.1% to $61/bbl as major forecasting agencies warned that higher output from OPEC+ and other producers will keep supply well ahead of demand; US natural gas prices fell 22.1% from the Dec 5 peak, which had been caused by a cold weather spell, with warmer weather expected, while European gas rose 2.3%.

Market monitors

Volatility rose for equities and for bonds (VIX = 16, MOVE = 69); the 10-year average for each is VIX=19, MOVE = 80. Market sentiment (at midweek) remained optimistic at +14 as investors look to renewed economic growth in the new year.