Hi YXI friends,

During this week's January FOMC, the Fed decided to maintain its current interest rate levels, refraining from further cuts. The Fed Funds rate remained within the range of 4.25% to 4.50%, with the Effective Federal Funds Rate standing at 4.33%.

Since the Fed’s initial September rate cut of 50 basis points, the labour market has been surprisingly resilient, with unemployment ending the year at 4.1% in December. The Fed currently sees little downside risk to a normalising labour market, even as Trump’s immigration policy could reduce the labour supply.

However, inflation is still a headache. In the December FOMC projections, the Fed has revised up the 2025 inflation expectations to 2.5% for both the Headline and Core PCE readings.

Now, let’s review the latest PCE data, my thoughts on the FOMC path in 2025, the uncertain impact of tariffs, and the price technicals of TLT.

Table of Contents

• 1. December PCE Readings

• 2. The 2025 FOMC Path

• 3. Impact Of Tariffs Is Uncertain

• 4. Treasury Issuances

• 5. 10-Year Bond Yield, TLT

• 6. Holding Bonds For Diversification

DISCLAIMER: This newsletter is strictly educational. Any information or analysis in this note is not an offer to sell or the solicitation of an offer to buy any securities. Nothing in this note is intended to be investment advice and nor should it be relied upon to make investment decisions. Any opinions, analyses, or probabilities expressed in this note are those of the author as of the note's date of publication and are subject to change without notice.

1. December PCE Readings

The December PCE data came in line with expectation. While may provide some comfort of no ugly surprises to the market, the data themselves unlikely motivate the Fed to cut any time soon.

Headline PCE vs Core PCE, YoY%

The latest PCE figures from Friday showed that the Headline PCE came in at 0.3% MoM, which meant the YoY figure rose again in December, from 2.4% to 2.6%.

Core PCE was 0.2% MoM, while the YoY change remained sticky at a high 2.8%, the third time in a row.

The “good” news is that on a 3-month annualised basis, Core PCE is reading 2.4% and could be trending to finally drag down the 12-month figure.

5-Year Inflation Expectation Hurdle

Using the Inflation-adjusted Bonds’ Breakevens (TIPS), we observe that the 5-year inflation expectation has run into an 18-month high, nearly all of the rise comes right after Fed’s 50bp cut.

However, this is also a near-term resistance zone. The inflation expectation has not managed to sustain above the 2.5% level in the past 1.5 years. Today, the key for its retreat relies on a benign oil price (which we may not get in Q1), as well as clear, not-too-aggressive tariff polices from Trump.

2. The 2025 FOMC Path

The FOMC Projection By Fed Funds Futures

Using Fed Funds Futures, we can interpolate the market expectations of what happens in each of the FOMC meetings for the next 24 months. Currently, the market prices in exactly 2 cuts for 2025.

I would agree with the Fed Funds futures that the first cut comes no sooner than June.

Why? The Fed is in a clear wait-and-see mode for at least a full set of Q1 CPI and PCE reports, plus clarity around the impact of Trump’s exact tariff policies on consumer spending. They won’t have the confidence to cut (risking inflation resurgence) until they have this fuller picture.

But is it the right thing to do? The Fed’s monetary policy has an 18-month lag, so they could well be behind the curve. But they can only act with the new data in front of them, rather than try to front-run (which Yellen did, but unsuccessfully under her tenor). Moreover, one can argue that Trump’s policy is a new exogenous shock that may change the monetary policy outlook.

3. Impact Of Tariffs Is Uncertain

Trump’s Treasury Secretary, Scott Bessent, is a renowned macro hedge fund manager who understands the danger of a collapsing bond market (sending yields higher) if he failed to manage the tariff policies as well as the budget deficit issues.

Bessent prefers a more gradual approach to tariffs, as recently reflected in Trump’s calmer-than-expected stance on China. Instead of the 60% tariffs Trump underlined during his campaign, China will only receive a 10% tariff from February. Canada and Mexico, however, will see 25% tariffs instead.

Tariffs are effectively a tax paid by the importers at the custom, but it does not automatically lead to inflation. There are a number of factors.

The importers distribute goods via retailers or directly online. Whether tariffs drive up prices depend on the price elasticity of demand for the exact items. If there are readily available substitutes that customers can switch to (e.g. coffee beans), the retailers may not be able to pass on the extra cost. Instead, the importers likely shy away from the tariffed products. However, if the goods enjoy price inelasticity (e.g. high end washing machines), the retailers can more easily hike the price to reflect the new costs. In this case, customers may choose domestic brands.

Furthermore, the USD price fluctuation also depends on how the exporters set their price. There is an argument that a stronger USD can offset the tariff impact in dollar terms, but that’s if the exporter sets price in their domestic currency. A lot of exporters, who import materials in USD, may also set the price in USD to keep margins consistent. In this case, they need to voluntarily lower their exporting prices to avoid a demand drop. Alternatively, they can reroute their exports via a third country, which China did via Vietnam in 2018.

The “inflationary impact” also depends on the weighting of the importated goods and materials in the government’s CPI and PCE calculation. A study by Peterson Institute For International Economics estimated that tariffs on China in 2021 (66% of Chinese imports at 19.3% average tariff) only contribute to 0.26% of CPI and 0.35% of PCE, as China imports only account for 2-3% of goods included in these inflation indices.

Finally, tariffs are transitory costs - they affect the prices just once and can be later removed. Bessent also argues that tariffs aren’t inflationary because if people’s disposable incomes do not change, they will spend less money on non-tariffed goods, which should net off the overall impact.

4. Treasury Issuances

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