Hello, and welcome to our first Market Compass episode of 2025. The year has started with optimism about the outlook for the economy and corporate profits, but also with some uncertainty about interest rates and inflation.
One notable move impacting performance early on is the rise in bond yields. The 10-year Treasury yield briefly touched 4.8%, a 14-month high, before subsiding after the encouraging December inflation data.
In this episode, we share our thoughts on what’s driving bond yields higher and how much further they can go. We’ll also touch on the implications for portfolios.
First, why are yields rising?
A mixture of good and bad news is driving this recent rise. On the positive side, the economy has been performing better than expected, and 2024’s theme of economic resilience appears poised to continue.
Whether we’re looking at solid job growth, robust consumer spending or improving business sentiment, all suggest the U.S. economy continues to chug along, a bright spot relative to other major economies. As a result, the Federal Reserve, which cut interest rates by one percentage point last year, is feeling no urgency to cut them further.
The bad news comes from some reemerging inflation worries. Progress on that front has slowed over the past six months. Looking at the breakdown of the increase in the 10-year Treasury yield since September, about a third of it is explained by the rise in inflation expectations.
And finally, there is some uncertainty about potential policies from the new administration and elevated government debt at a time when unemployment is historically low, which is an unusual combination.
Because of these three reasons — strong U.S. growth, lingering inflation pressures and policy uncertainty — investors have meaningfully reduced their expectations for interest rate cuts this year. The bond market is now pricing in fewer than two rate cuts by the end of 2025, down from 10 in September. This is a big adjustment, but the pendulum may have moved too far.
Next, how much higher can yields go?
While predicting interest rates is notoriously difficult, without the Fed going back to hiking rates, we believe yields may have a hard time moving sustainably higher from here or exceeding the prior cycle peak of almost 5% reached at the end of 2023.
To that end, history provides some comfort. Yields have tended to peak around the end of Fed rate hikes in every cycle going back 40 years.
This was the case in the mid-1990s, which was the last time the Fed achieved a soft landing. The economy never weakened substantially, and the Fed cut rates only three times before a prolonged pause. During this time, the 10-year yield rose about 1.5%, which is similar to the recent increase, but it never returned to its prior peak.
We do not see rate hikes on the horizon; in fact, we expect at least one rate cut from the Fed this year, with two a reasonable base case. Navigating the last mile of inflation to reach the 2% target is proving to be bumpy, but the inflation trend remains lower. Highlighting this point, December’s CPI data were encouraging, with core inflation posting its first drop since July.
The key takeaway is that the bond selloff might have gone too far. With the fed funds rate at 4.5%, which is still comfortably above the inflation rate of around 3%, Fed officials have room to cut at a slow pace.
And finally, what does this mean for your portfolio?
Higher rates have triggered some volatility for both stocks and bonds, but this is a familiar dynamic as we think about how markets have progressed over the last couple of years.
Back in the summer of 2023, the 10-year Treasury yield briefly exceeded 4.5%, leading to a 10% pullback in the S&P 500. It crossed 4.5% again in April of last year, with stocks briefly declining 5%. In both cases, the bull market stayed intact, supported by solid fundamentals.
We think this will be the case this time as well. We see the economic expansion continuing, the labor market stabilizing at healthy levels, and earnings growth accelerating. While it is still early, the earnings season that kicked off with the banks in mid-January is sending a positive signal about the health of corporate America. For the fourth quarter, S&P 500 earnings are expected to increase 11%, which would be the strongest growth in three years.
Additionally, the silver lining behind the volatility of December and early January is that it helped unwind some investor sentiment extremes. In October, twice as many investors surveyed anticipated market increases rather than declines, while the same ratio of bulls to bears is now slightly under one, indicating more balanced sentiment.
Even though the Fed’s path and the new administration’s policies are somewhat uncertain, we think this reset in expectations paves the way for the next leg higher in stocks.
On the fixed-income side, consider using the rally in yields as an opportunity to review your allocations to cash investments and possibly reposition to intermediate investment-grade bonds. These bonds now carry higher yields than those of CDs and money market funds. The best predictor of future returns of high-quality bonds tends to be their starting yields, which are currently near a 20-year high.
To sum up, volatility might be elevated this year, but we recommend using any pullbacks as opportunities to deploy fresh capital and rebalance portfolios aligned with your risk tolerance and long-term goals.
For more market insights and strategies to consider that may be appropriate for you, contact your Edward Jones financial advisor.