Written by Steve Andrews
Happy New Year?
As of mid- January, the S&P 500 index has fallen 2.5% from its record high back on December 6th. Over that same time span, the yield on the 10-year Treasury Note has climbed from 4.15% to 4.66%, as Treasury bond prices fell along with stock prices, and is up nearly a full percentage point (1.00%) since the Fed began to cut the Fed Funds rate last September. The bullishness felt by investors in early December has waned. Why?
The Fed directly controls short-term interest rates via the Fed Funds rate but the further out the yield curve a maturity goes from the Fed Funds rate (2 years, 5 years, 10 years, etc.), the less control the Fed has, and the more impact market forces (investors) have. Bond market investors have been pushing long-term rates higher for a number of reasons:
- Recession: The recession many feared over the past 12 months failed to materialize and rates are reacting and adjusting to stronger economic growth.
- Inflation: The path of deflation has slowed, and bond yields are rising to compensate investors for higher inflation expectations.
- Politics: While the elections have boosted economic optimism and growth projections, the proposed tariffs and tax cut extensions are adding to investors’ inflation angst.
- Deficits: Investors worry, too, over the federal deficit and the amount of debt coming to market in 2025 – expected to exceed $7 trillion, which is about double that of 2024 – and more supply versus softer demand would lift bond rates higher.
- Normalization: Lastly, lowered expectations for Fed rate cuts this year (from the minutes of the December FOMC meeting) raises the expected “break-even” level for the 10-year Treasury. If Fed Funds end the year at 4.08% (assuming one 0.25% cut this year), the break-even rate for the 10-year Treasury would be @ 5.03% (the long-term historical average of 0.95% above the Fed Funds rate).
Economic Expansion Amid Market Volatility
US stocks and bonds have had a rough ride since early last month, but the markets are not the economy. Market prices can fluctuate based on short-term angst (and euphoria) but, despite the market volatility, the US economy continues to expand. The US services sector makes up over 80% of the economy and continues to drive growth. The ISM services index rose 2 points in December to 54, and its two most forward-looking subsets (new orders at 54.2, and business activity at a red-hot 58.2) point to continued growth in the months ahead. While US manufacturing continues to waffle, manufacturing growth is getting less soft. The ISM manufacturing index rose to 49.3 in December - the strongest reading in nine months. The rise dovetails with separate reports from S&P Global which have indicated some firming up in the US manufacturing sector over the last three or four months.
Housing, too, is showing signs of pulling itself out of the doldrums. Pending Home Sales rose 2.2% in November – their 4th consecutive monthly gain - suggesting an increase in existing home sales for December and January. According to the National Association of Realtors, home buyers appear to have gotten over mortgage rate sticker shock and are no longer waiting for mortgage rates to fall to take advantage of rising home inventory.
Consumer Strength and Job Growth
While the markets muddle along, trying to decipher the new administration’s policy details, the US consumer (whose spending drives 70% of US GDP) continues to carry the economy on their collective backs as they have since the economy reopened. Consumer spending remains formidable. While sales at restaurants and bars have receded some from red-hot levels, spending on travel, cars, and internet purchases remain robust. Despite concerns to the contrary, they show few signs of slowing down, fed by record household net worth and rising incomes supported by a strong labor market. Job growth over the past 12 months has averaged 185,000 per month but, over the past three months (which includes storm-ravaged October) job growth has averaged 192,000 per month. Job growth exceeded expectations in December and total earnings (wages plus hours worked) were up 5.0% from December 2023 - well ahead of inflation.
Business Optimism and Inflation Trends
Since the elections, both consumer and business optimism continue to rise, and many companies, still running lean and mean following the shutdowns, are getting ready to expand and invest, inspired by expectations of lower regulatory burdens and taxes. December US Small Business confidence rose to its highest level in over six years, after a record increase in November. The share of businesses expecting better conditions in the months ahead jumped 16 points to the highest level on record since 2002.
In addition, the December inflation data should make the Fed feel a little bit more confident as it lifted the markets. Consumer prices (CPI) eased slightly from November levels as sticky shelter (housing) costs continue to moderate. Once the Fed concedes that employment growth is not a problem (even if inflation remains a bit of a problem) and announces a hold on further rate cuts, the markets should settle down. We are just beginning to see the first of Q4 corporate earnings reports, and we would not be surprised if results once again exceed expectations and add some lift to US stocks.
Outlook for the Bull Market
The stock market jubilation that we chronicled last month has died down but the recent rise in interest rates should not derail the bull market. While interest rates impact valuations, stock prices are fed by earnings growth and, given current economic fundamentals, earnings growth should continue, and nurture stock prices. From where we sit, the rise in long-term rates has been more of a normalization process, as noted above, and not the start of a march to the double-digit interest rates of the early 1980s. In the meantime, the US economy continues to grow, fed by consumer demand, abundant liquidity, and rising productivity, boosted by constantly evolving, innovative technologies.
