The Federal Reserve may need to reverse at least a 75-basis-point "insurance cut" as risks of excessive tightening rise in tandem.
Author: Wu Yu, Jin10 Data
As whether AI trading can continue remains a focal point for the market, investors may also need to be wary of another risk: the Federal Reserve's overly tight monetary policy aimed at curbing inflation could become a significant threat facing U.S. stocks in 2027.
Neil Dutta, Director of Economic Research at Renaissance Macro Research, told MarketWatch on Tuesday that the current labor market is strengthening, the unemployment rate is falling, yet inflation is moving further away from the Fed's 2% target.
This combination significantly increases the risk of policies being tightened excessively. "I do believe that excessive tightening is a major risk," Dutta said.
Federal Reserve Governor Christopher Waller signaled on Tuesday in London during a speech that interest rates might need to be raised further.
He stated that if the October CPI data released on that day resembled the previous two months, with core CPI reaching a monthly rate of 0.3% or higher, the Fed might need to take stronger policy action and should consider raising rates by 50 basis points at its December meeting.
Subsequently released data showed that the October core CPI monthly rate was 0.3%. Following the release, U.S. Treasury yields rose sharply, with the 10-year yield returning to 5%.
Inflation Pressures Rebuild, Rate Hike Magnitude May Exceed Market Expectations
Dutta believes it remains to be seen whether Waller's stance will gain support from other Fed governors. However, the latest economic data suggest that current interest rates may still be insufficient to effectively curb rising prices.
Although crude oil prices have fallen since the U.S. midterm elections, refined products like diesel remain at elevated levels. Meanwhile, housing costs are beginning to show signs of accelerating, further complicating the downward trend in inflation.
Dutta pointed out that the October inflation data released on Tuesday indicates that shelter costs for renting homes may be re-accelerating. If the pace of housing price growth does not slow down, it will be difficult for the Fed to bring overall inflation back to its 2% target.
He wrote in a report sent to clients on Tuesday: "In short, the Fed remains too optimistic about inflation, and the market is too complacent about the degree of tightening needed to achieve its inflation target."
Treasury Yields Spike as Markets Reprice Rate Hike Path
The bond market has begun reflecting expectations for a tougher monetary policy. Dow Jones Market data shows that on Tuesday, the two-year U.S. Treasury yield, most sensitive to Fed rate expectations, rose 19 basis points to 4.75%, marking its largest single-day increase since Trump announced tariff policies in April 2025 that disrupted global markets.
The widening gap between the 2-year Treasury yield and the Fed's policy rate also reflects bond investors signaling to the central bank: the market anticipates larger rate hikes ahead.
Currently, investors expect the Fed to cumulatively raise rates by another 50 basis points over the coming months, aligning with the latest forecasts released by senior Fed officials in September. This means the 75-basis-point "insurance cut" implemented by the Fed in 2025 will be fully reversed.
But Dutta believes that merely reversing the previous cuts may already be insufficient. He wrote in his report: "For now, unwinding last year's insurance cut is only the bare minimum requirement."