What are rising bond yields telling us?
The bond market is sending a clear signal: despite the Federal Reserve’s recent rate cuts, the risk of reflation is rising. This means that inflation, which had been cooling, may be heating up again. This is reflected in the yields on US Treasury bonds, which have been climbing steadily. The 10-year US Treasury yield has surged to 4.7%, its highest point in eight months, while the 2-year yield at 4.3% is now aligned with the Fed’s target rate, indicating that the market no longer anticipates further rate cuts.
Several factors are contributing to this shift. Firstly, the economy remains strong, defying expectations of a slowdown. Secondly, persistent inflation, particularly in the services sector, is fueling concerns that the Fed’s rate cuts were premature. On Tuesday, the ISM services price index was reported at its highest level since early 2024, underscoring this worry.
Adding to the uncertainty are the potential economic impacts of the incoming Trump administration’s planned policy changes. These changes are contributing to a reassessment of inflation expectations and the future direction of Fed policy. There are also concerns about the increasing size of future bond issuance that will be needed to fund growing government deficits. Investors are grappling with the possibility that these policies could further stimulate the economy and exacerbate inflationary pressures.
The bond market is essentially pricing in the risk that the Fed may have made a policy error by cutting rates too soon. If inflation continues to rise, or stubbornly hover at current levels, the Fed may be forced to reverse course and hike rates to cool the economy. This uncertainty is leading investors to demand a higher premium on bonds to compensate for the increased risk.
The rising bond yields serve as a warning sign that the fight against inflation is not over. The Fed will need to carefully monitor incoming economic data. The possibility of further rate cuts appears to be off the table for now. Interest rate futures investors are pricing in less than a 20% chance that the Fed cuts rates more than two times in 2025. Yesterday’s published Fed meeting minutes showed that most members are concerned about the potential inflationary impact of Trump’s proposed tariffs and trade policy.
In fact, the December Fed meeting minutes reveal a more hawkish stance than previously perceived, with policymakers emphasizing upside risks to inflation and expressing caution about further rate cuts. Despite still viewing rates as restrictive, the Fed acknowledges the need for eventual rate reductions to reach neutral levels. The minutes highlight increased concern over inflation due to recent strong economic data and potential policy changes, leading to a “wait-and-see” approach with no immediate plans for further cuts.
Remember that the stock market declined 3% in December on the day that Fed Chairman Powell surprised investors with his more hawkish view on future rate cuts. Higher interest rates and bond yields are generally not good for equity investors unless earnings growth is very strong. This is the question we now face: Will earnings growth be strong enough to support historically high valuations if interest rates and bond yields have already bottomed?
What’s next following the remarkable gains in 2023 and 2024?
The S&P 500 index gain of more than 50% over the past two years has been nothing short of impressive. However, history tells us that periods of exceptional gains often precede periods of correction. Current market valuations, particularly for leading tech companies, are beginning to be reminiscent of past bubbles, raising concerns about the sustainability of this growth. While these companies possess undeniable strengths, strong current earnings, and potential growth, investors seem to be pricing in decades of uninterrupted success, a scenario that rarely plays out as expected.
The S&P 500 P/E ratio for 2025 earnings is 22x, well above its historical average. This suggests that investors are paying a premium for future earnings, betting on continued growth and market dominance. While optimism is understandable, especially in light of exciting advancements like AI, it’s crucial to remember that even the most innovative companies face competition and technological disruption. The graveyard of once-dominant companies serves as a stark reminder that past performance is no guarantee of future success.
It’s tempting to dismiss these concerns, especially when the market continues to climb. However, the relationship between starting valuations and subsequent returns is well-established. High P/E ratios, like those we see today, have historically been followed by lower returns over the next decade. Unfortunately, P/E ratios are not very good at predicting returns over shorter periods, such as one-year. While a modest return might seem acceptable, the real risk lies in the potential for a rapid market correction, where inflated valuations quickly deflate, leading to significant losses.
This is not to say that a crash is imminent or inevitable. However, prudent investors should acknowledge the warning signs and temper their expectations. Chasing high returns in an overvalued market can lead to disappointing outcomes. Instead, a more cautious approach, focused on value and diversification, may be more appropriate in the current environment.
The market’s exuberance, particularly surrounding AI and other technological advancements, warrants a healthy dose of skepticism. While the future is undoubtedly bright, it’s crucial to remember that even the most promising companies can falter. Investing with a long-term perspective, grounded in realistic expectations, is essential for navigating the inevitable ups and downs of the market.
Today, we honor and mourn the loss of Jimmy Carter, our 39th U.S. President. It is also the birthday for musicians Dave Matthews and Jimmy Page, and Catherine, Princess of Wales, aka Kate Middleton.
Christopher Gildea
610-260-2235