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Summary

After a strong 2024 for the S&P 500, driven by factors like Federal Reserve (Fed) rate cuts and a presidential election, the market’s outlook for 2025 is shifting. While 2024 saw the Fed pausing rate hikes (the second-longest pause in the central bank’s history) and then initiating cuts, culminating in a strong market rally after the election, the year ended with the Fed tempering expectations for further cuts. This caused market jitters, with the S&P 500 experiencing its steepest decline after a Fed meeting in nearly 25 years.Looking ahead, increased market volatility across stocks, bonds, commodities, and currencies is expected. This volatility is tied to potential policy changes, particularly in trade. The primary drivers of market performance in 2025 are likely to be interest rates and currencies, as the “bond vigilantes” regain influence.

Markets Likely Held Hostage by the Bond Market in 2025
As James Carville famously said, “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.” This highlights the power of the bond market to influence economic conditions.Historical examples underscore this influence. The “Great Bond Massacre” of 1993-1994 saw 10-year US Treasury (UST) yields surge from just over 5% to 8%, causing significant losses for bond investors. More recently, in 2022, pandemic-related stimulus fueled inflation, pushing 10-year UST yields from 1.5% to nearly 4.5% and 30-year fixed-rate mortgages from roughly 3.25% to almost 7.5%. This global surge in yields resulted in over $23 trillion in combined market value losses for bonds and stocks.Since September of last year, yields have been rising again globally, resulting in approximately $11 trillion in combined losses for bond and stock markets.The key question is: why are yields rising, and can this trend continue? Several factors are contributing to this rise:

These factors suggest that the increased supply of government debt, and therefore upward pressure on yields, is likely to persist. This will likely make global stock markets highly sensitive to interest rate movements in 2025.

The Scale of Debt Refinancing
The scale of government debt refinancing in 2025 is substantial. G10 countries collectively have nearly $14 trillion in maturing debt, with the US accounting for over $10 trillion (30% of its outstanding debt). This massive rollover poses a significant challenge for markets.I’d like to draw your focus to the central column in the table below, which shows the current average coupon rate for outstanding US debt. As of now, the US is servicing its debt at an average rate of 2.71%. However, this rate is poised to increase significantly because:

This means that the refinancing cost for the debt maturing this year could surge by 55% to 87%, depending on the mix of new debt issued by the US Treasury.However, the United States is not alone in facing this refinancing challenge. The table below highlights similar issues with debt issuance and refinancing for other countries as well. Source: Financial Sense Wealth Management, Bloomberg

What’s a Central Bank to Do?
Central banks typically react to past economic data (primarily labor markets and inflation) rather than proactively anticipating future trends. This often results in them reacting to, rather than preventing, inflationary cycles.Historically, inflation peaks and troughs tend to precede central bank policy changes by 12-18 months. Currently, the decline in global inflation appears to be stabilizing around 3-4%. Unless inflation falls substantially from this level, further rate cuts by central banks are unlikely. This potential halt to the easing cycle could negatively impact equity markets.Furthermore, if investors expect rising inflation, they are unlikely to welcome further rate cuts, perceiving them as adding fuel to the inflationary fire. This could trigger selling in the UST bond market. This might be exactly what we are witnessing currently as the bond market’s reaction to the Fed’s easing cycle has been anything but typical as historically the Fed cutting rates is associated with bond yields falling and bond prices rallying. However, in the current cycle the Bloomberg US Long Treasury Index is down 12% since the Fed started cutting rates, the worst performance following the onset of a Fed easing cycle going back to 1974.

The Fragility of the UST Market
Large structural deficits and waning foreign demand for US debt are contributing to a supply-demand imbalance, pushing interest rates higher and increasing bond market volatility. The growing reliance on US hedge funds, known for their leveraged strategies, further amplifies this volatility.The UST has implemented a buyback program to support the market and reduce volatility, spending $43 billion in its first five months (equivalent to $103 billion annually). This intervention underscores the fragility of the UST market.
Clearly, the UST market is becoming more fragile by the day as we can’t rely on the kindness of strangers as we have in the past, but rather on less benevolent lenders like hedge funds. Much like someone down on their luck having to go to a bookie, the US Treasury needs to find a more reliable borrower or risk losing control of interest rates in the US.

Potential for Fed Intervention
The Treasury Borrowing Advisory Committee (TBAC), which advises the US Treasury on debt management, recently released a report with key insights. A supplemental report (click for link) from the Inter-Agency Working Group (IAWG) projected that the Fed will stop shrinking its balance sheet by mid-year and then resume growth at 5% per year indefinitely as foreign ownership of Treasuries has fallen from 35% in 2010 to 15% currently.
This projection raises questions: Why would the Fed need to intervene if the economy is expected to accelerate? This suggests the UST market may be less robust than perceived. If inflation returns and the US dollar strengthens, forcing foreign holders to sell USTs, a potential “riot” in US Treasuries could force the Fed to intervene with monetary easing, potentially leading to USD devaluation as it rides to the rescue. While the IAWG’s current estimate is the Fed moves towards debt monetization next year, our feeling is that we are likely to see helicopter drops of money far sooner than that if yields do not stop their relentless march higher. Given our outlook for inflation to return this year, a sizable decline in interest rates appears to be a low probability event.

Inflation: The Breaking Point for the Bond Market?
Several indicators we follow now point to a potential resurgence in inflation. We track various early warning signs, and they consistently suggest upward pressure looking forward.The San Francisco Fed has developed a useful way to categorize inflation:

Historically, changes in acyclical inflation tend to precede changes in cyclical (and overall) inflation. The recent uptick in acyclical inflation suggests that overall inflation may have bottomed out and is likely to rise through 2025. This is unwelcome news for the Fed, which had hoped for further rate cuts, and for the bond market, which was anticipating lower inflation and interest rates. Source: Bloomberg, Financial Sense Wealth Management
Adding to these concerns, the ISM Service Index recently showed a sharp increase in its “prices paid” component. This is significant because it often foreshadows changes in the Consumer Price Index (CPI) by several months, further supporting the San Francisco Fed’s data. Source: Financial Sense Wealth Management, Bloomberg

The Danger of Unanchored Expectations
A key goal for the Fed is to “anchor” inflation expectations among both businesses and consumers. If people expect inflation to spiral out of control, they will demand higher wages, and businesses will raise prices to cover increased costs. This creates a dangerous feedback loop, driving prices and wages ever higher. As the 1970s demonstrated, controlling inflation once it takes hold requires drastic measures, such as double-digit interest rates.Despite experiencing the highest inflation rates in over 40 years, long-term inflation expectations remained relatively stable, with consumers generally viewing the recent spike as temporary. However, this is changing. The University of Michigan’s Consumer Index shows that 5-10-year inflation expectations have reached their highest level since 2008, a time when inflation was around 6% and oil prices were nearing $150 a barrel. Unlike the 2021-2023 inflation spike, which didn’t significantly impact long-term expectations, current consumer expectations for future inflation are rising rapidly, reaching a 17-year high.

The Impact on Bond Yields and Term Premium
If bond investors believe inflation is set to rise, they will demand higher interest rates on longer-term bonds to compensate for the increased risk of future inflation eroding the value of their investment. This extra yield is known as the term premium. It’s the additional return investors require for holding longer-term bonds compared to repeatedly reinvesting in shorter-term debt.The term premium hasn’t been a significant concern for over a decade, but this is now changing. A rising term premium signals that governments are losing control of their bond markets.
In the mid-to-late 1960s, before inflation surged, the 10-year term premium was close to 0%. This meant that investors saw little risk of significantly higher interest rates over the next decade. However, by the early 1980s, as inflation soared, the term premium had risen to over 5%, reflecting dramatically increased inflation expectations.The relationship between the 10-year UST yield and the 10-year term premium is clear. Worryingly, the term premium has recently hit a 10-year high. Further increases will put upward pressure on bond yields, creating a challenging environment for both stock and bond markets.

Outlook and Strategy
After a relatively calm period for the bond market and US dollar (USD), these markets have recently shown signs of volatility, with bond yields near two-decade highs. A surge in yields could create a challenging environment for stocks, potentially mirroring the market downturn of 2022.Given these risks, we believe a move towards a neutral allocation in risk assets is currently warranted—something we began implementing in portfolios at the end of last year. A patient approach, monitoring market data and adjusting strategies accordingly, is advisable. If concerns about interest rates, the dollar, and inflation prove unfounded, our investment focus will likely move back onto growth areas like AI, robotics, energy for data centers, and quantum computing. However, if these concerns materialize, higher cash positions should provide opportunities to invest at more attractive valuations.Increased volatility is expected in 2025. Careful monitoring and prudent risk management are essential for navigating this evolving market landscape. As always, we are here to serve our clients and if you have any questions regarding your portfolios or our investment strategy, please do not hesitate to reach out to your wealth advisor.More By This Author:What Lies Ahead In 2025? Slower Growth, More Volatility
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