PCE Comes In Hot and Rate-Cut Hopes Cool Fast

U.S. markets spent most of the week balancing three forces that do not play nicely together: inflation that is proving stubborn, growth that is losing momentum, and policy headlines that can change the risk outlook in minutes. Friday tied it together. A stronger-than-expected PCE inflation report pushed rate-cut expectations further out, while a major U.S. Supreme Court tariff decision briefly boosted risk sentiment before investors immediately started debating refunds, fiscal fallout, and what policy comes next.

PCE surprised to the upside, and “lower rates soon” got harder to price

The Fed’s preferred inflation gauge came in hotter than markets wanted. In the BEA’s Personal Income and Outlays report for December 2025, the PCE price index rose 0.4% month over month, and core PCE (excluding food and energy) also rose 0.4%. Year over year, headline PCE was 2.9% and core PCE was 3.0%.

Why it matters: PCE is central to the Fed’s inflation story. When the underlying monthly pace runs hot, traders tend to push out the timing (and sometimes the size) of potential rate cuts. A widely cited way to track how the market is pricing upcoming Fed meetings is CME’s FedWatch Tool, which converts fed funds futures pricing into implied probabilities.

Growth is cooling, and the data is starting to show it

Alongside inflation pressure, the growth picture weakened. The BEA’s advance estimate showed real GDP grew at a 1.4% annual rate in Q4 2025. The release also noted that the October–November 2025 federal government shutdown subtracted about 1.0 percentage point from Q4 real GDP growth because of reduced federal services.

This is the “bad mix” for markets: slower growth can hurt earnings momentum, while sticky inflation keeps policy restrictive. It is a setup where investors tend to reward dependable cash flows and punish business models that rely on cheap capital and distant profitability.

The Supreme Court tariff ruling sparked a rally, then raised fiscal questions

A major policy catalyst hit Friday: the U.S. Supreme Court ruled that IEEPA does not authorize the President to impose tariffs, striking down Trump’s global tariffs in a 6–3 decision (Chief Justice Roberts wrote the majority opinion).

Markets initially treated the ruling as risk-positive, but the second-order questions landed immediately:

Refund exposure: If large amounts of previously collected duties are refunded, that is a direct fiscal issue. Reuters noted the Court did not address how refunds would work, leaving uncertainty for businesses and the Treasury.
Deficit sensitivity: The backdrop here matters. CBO’s latest outlook projects a $1.9T federal deficit in FY2026 and a rising debt path over the next decade, which is why sudden changes to revenue or refund liabilities can quickly become a bond-market topic.

Oil stayed elevated on geopolitics, not just supply-demand math

Energy remained headline-driven. Reuters reported oil near six-month highs and heading for a weekly gain as U.S.–Iran tensions increased, with Brent around the low $70s and WTI in the mid $60s during Friday’s session.

The strategic reason this keeps leaking into macro: the Strait of Hormuz remains a critical chokepoint. The U.S. EIA estimates oil flows through Hormuz averaged about 20% of global petroleum liquids consumption in 2024, which is why markets can reprice risk premiums quickly when tensions rise.

The dollar stayed a key transmission channel for tighter conditions

With inflation still sticky and the policy outlook uncertain, currency moves mattered. A stronger dollar can tighten global financial conditions, pressure commodities, and weigh on parts of the market that rely on external financing. The Fed’s H.10 framework describes its broad trade-weighted dollar indexes, and FRED publishes the Nominal Broad U.S. Dollar Index (DTWEXBGS) as a commonly referenced benchmark.

AI spending remains massive, but investors want returns—not just investment

The AI trade stayed dominant, but the tone has shifted from excitement to scrutiny. Reuters’ survey of Big Tech results highlighted the scale of planned spending and the investor debate around return on capital and margins.

On the “compute supply chain” side, Nvidia remains a focal point. In its fiscal 2026 third-quarter release, Nvidia reported record revenue of $57.0B and record data center revenue of $51.2B (up sharply year over year), reinforcing why chips and infrastructure continue to anchor the AI complex.

Software is still being repriced, largely because discount rates still matter

The software “reset” has looked less like a single event and more like an extended valuation adjustment. When rates stay higher, the market typically applies a harsher discount to long-duration cash flows, which can pressure high-multiple growth stocks even if revenue is still growing. NYU’s Aswath Damodaran lays out the mechanics of discount rates and valuation sensitivity that help explain why rate expectations can move software multiples so quickly.

Bottom Line

This week reinforced a simple message: when inflation re-accelerates and growth slows, markets become less forgiving. Policy also re-entered the frame in a big way, with the tariff ruling creating short-term relief but introducing new uncertainty around refunds and fiscal math. Meanwhile, energy risk premiums stayed tied to geopolitics, the dollar remained a meaningful constraint, and AI investment continued—under increasingly strict investor scrutiny.

Sources

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