Weekly market wrap

Did the pendulum swing too far on rates?

Key Takeaways: 

• Last week the benchmark 10-year Treasury yield briefly touched a 14-month high at 4.8% before retreating following encouraging inflation data. Core CPI unexpectedly edged lower to 3.2% from 3.3%, the first drop since July, providing relief to both stocks and bonds.
• Against a backdrop of strong economic growth, a bumpy disinflation process, and policy uncertainty, the Fed is feeling no urgency to cut rates further, and investors have meaningfully scaled back their expectations for rate cuts this year. However, the bond sell-off might have gone too far.
• Without the Fed going back to tightening mode, we believe yields may not move sustainably higher from here or exceed the prior cycle peak of almost 5% reached at the end of 2023.
• While interest rates impact valuations, the start of the earnings season is a good reminder of the influence that earnings have in driving the stock-market direction and returns. Bank results point to a solid quarter for S&P 500 earnings.
• Even though the Fed’s path and the new administration’s policies are somewhat uncertain, we think the reset in investor expectations over the past couple of months paves the way for the next leg higher in stocks. If yields stabilize, we could see a revival of the value, cyclical, small- and mid-cap outperformance that fizzled in early December.

The early days of 2025 have delivered plenty of market headlines, some volatility, and further evidence of economic and corporate strength. However, the biggest surprise has likely been the magnitude and speed of the rise in bond yields. What might traditionally be considered good news for the economy has instead been interpreted as bad news for markets when viewed through the lens of inflation and Fed policy.

Has the pendulum of expectations swung to the other extreme? Investors who were once overly confident in the Fed's willingness to cut rates may now be underestimating its flexibility. Here's our perspective on recent Treasury market gyrations.

1) Rates are starting to pressure stock valuations

Last week, the benchmark 10-year Treasury yield briefly touched a 14-month high at 4.8% before retreating following encouraging inflation data¹. This marked the third time since the start of the bull market in October 2022 that the 10-year yield exceeded 4.5%, a threshold that in the past has triggered some indigestion for equities. The first instance was in summer 2023, which triggered a 10% pullback in the S&P 500, and the second was in April of 2024, resulting in a 5% decline¹. Despite these pressures, the bull market remained intact, supported by solid fundamentals. We expect the same outcome this time as bond-market pressures ease.

2) What is behind the rise? A combination of factors, not just inflation.

Since mid-September, long-term government bond yields have risen about 1%, with roughly one-third of the increase attributed to higher inflation expectations. Oil prices, a key driver of short-term market expectations, have risen nearly 20%, though at $80 a barrel they remain in line with the past four-year average. Progress on core inflation, excluding food and energy, has also slowed over the past six months¹.

However, the rise in yields isn't solely an inflation story. U.S. economic growth during the same period has remained solid, supported by robust job growth, resilient consumer spending, and improving business sentiment. Pro-growth policies from the new administration may further sustain this momentum. On the flip side, the potential for stimulative fiscal policies and a tough stance on tariffs introduce some uncertainty into the inflation outlook, adding a risk premium to yields.

Against this backdrop of strong growth, a bumpy disinflation process, and policy uncertainty, the Fed is feeling no urgency to cut rates further, and investors have meaningfully scaled back their expectations for rate cuts this year.

3) December CPI helps ease fears of a reacceleration in inflation

With yields at multi-month highs, all eyes were on the producer and consumer price indexes last week, and the data provided some welcome relief. Headline CPI ticked up to 2.9% from 2.7%, driven by a jump in energy prices. But more significantly, core CPI unexpectedly edged lower to 3.2% from 3.3%, the first drop since July.

Progress on getting services inflation lower is slow. But, encouragingly, housing, the largest component of the CPI basket, rose 4.6% from last year, the smallest increase since January 2022. We see more scope for further moderation in shelter costs, as suggested by real-time rent data for newly signed leases. Wage growth, another key driver of service sector inflation, rose just 3.8% year-over-year in December, registering their smallest year-over-year increase since the pandemic. With productivity gains strong, current rates of wage growth are consistent with the Fed's 2% target¹.

The key takeaway is that the direction of inflation remains lower, and, despite recent concerns, we don’t expect a major reacceleration in prices. Yet, policymakers would need to see a series of subdued readings to gain more confidence about the progress and path forward.

4) Without rate hikes, yields may not move sustainably higher

Historically, bond yields have peaked around the end of Fed rate hikes in every cycle going back 40 years¹. This was the case in the mid-1990s as well, 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 peak¹.

Fed officials consider current policy restrictive, suggesting that even if progress on inflation stalls, they can keep rates at current levels to get the desired result. We think that the bar for rate hikes is high. Without the Fed going back to tightening mode, we believe yields may not move sustainably higher from here or exceed the prior cycle peak of almost 5% reached at the end of 2023.

The upshot is that the bond sell-off might have gone too far, and investors may revive rate-cut bets. 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 pace¹.

5) It's not all about rates; rising earnings a key to the bull market story

The start of the fourth-quarter earnings season is a good reminder of the influence that earnings have in driving the stock-market direction and returns. Interest rates can impact valuations, but the strength in corporate profits is a more sustainable driver of performance.

The banks kicked off the earnings season last week, delivering strong results and pointing to a favorable macroeconomic environment. More broadly, S&P 500 earnings are expected to increase 11% in the fourth quarter from a year ago, which would represent the strongest growth in three years². If S&P 500 earnings grow by 10% or more in 2025 as analysts expect, stocks can advance even after a modest decline in valuations (in this example the price-to-earnings ratio would need to fall below 19.5 from 21.5 currently to fully offset the gains from rising profits)².

6) Portfolio opportunities amid policy uncertainty

Policy headlines will likely dominate the narrative after Inauguration Day on Monday, with markets likely attempting to calibrate expectations for growth and inflation based on what's announced. Despite the uncertainty, the upside of the rout in the bond market in 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 sentiment¹. 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.

If yields stabilize or drop from here, we could see a revival of the value, cyclical, small- and mid-cap outperformance that fizzled in early December as rates moved higher. This dynamic was on display last week as the energy, materials and financials sectors all gained more than 5%, while tech and communication services were near the bottom of the leaderboard¹.

On the fixed-income side, the recent rally in yields provides an opportunity to review 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, which sets them up for some potential outperformance down the road. Historically, the best predictor of future returns of high-quality bonds is their starting yields, which are currently near a 20-year high¹.

Volatility might be elevated this year, but we recommend using pullbacks in both stocks and bonds as opportunities to deploy fresh capital and rebalance portfolios aligned with your risk tolerance and long-term goals.

Angelo Kourkafas, CFA
Investment Strategist

Sources: 1. Bloomberg, 2. FactSet

Weekly market stats

^{Source: FactSet, 1/17/2025. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results. *4-day performance ending on Thursday.}

The week ahead

Important economic releases this week include the Conference Board's leading economic index and S&P Global PMI data.

Review last week's weekly market update.