But still, with rate cuts being put off, the anticipation of those cuts allowed credit spreads to narrow and stock market multiples to soar.
In addition to the potential for tariffs to add to inflation in 2025, housing inflation may hurt again in 2025.
An inflation picture that remains sticky, stubborn, and above the Fed’s 2% target will make further rate cuts in 2025 even more challenging.
Falling Unemployment Rate, Faster Wage Growth Some survey data suggests that the job market may even improve in 2025.
Fed swaps are pricing in fewer than two rate cuts in 2025, with the next cut not coming until June.
The year 2025 is expected to be significantly different from 2024. The labor market is improving, inflation will remain higher than the Fed’s target rate, and the US economy is expected to continue to grow in 2025, according to numerous indicators. The improving outlook for the economy may mean that the Fed is nearing the end of its cycle of rate cuts, that hikes may resume in 2025, and that the 10-year Treasury (US10Y) is headed for a significant increase.
The SandP 500 (SP500) would likely lose all of its 2024 gains as a result of tighter financial conditions and wider high-yield credit spreads.
Given that the unemployment rate increased above 4 percent, inflation remained sticky, and there were fewer rate cuts than expected, 2024 had some unexpected turns that deviated from expectations. Nevertheless, the expectation of rate cuts caused credit spreads to contract and stock market multiples to rise as they were postponed. This indicated that, contrary to popular belief, even though three of the five predictions were accurate, it wasn’t enough to prevent the S&P 500 from ending at a new all-time high.
Inflation is expected to stay above target.
It’s likely that inflation will continue to be an issue in 2025 and remain higher than the Fed’s 2 percent target. Together, the PCE and CPI core measures averaged 3.0% as of November. As we proceed through the first half of 2025, there will be a significant upside risk to the expectation that inflation will decline in 2025.
Since September, when the Fed began reducing rates, inflation expectations have increased dramatically. Two-year inflation swaps returned to the upper end of the trading range since late 2022 after rising by almost 60 basis points to 2 point 56 percent.
Housing inflation could be a problem in 2025, in addition to the possibility that tariffs will raise inflation in that year. The CPI Owner-Equivalent Rent index typically lags behind the Case-Shiller home price index by 12 to 18 months. The owner-equivalent rent metric may see a recovery in 2025, as the Shiller index saw a significant recovery through March 2024 after plunging in May 2023.
The NFIB index, meanwhile, indicates that companies intend to increase prices. This index, which historically served as a leading indicator of the CPI, seems to have recently bottomed out. Should it keep rising, it would suggest that the CPI is rising as well.
More rate cuts in 2025 will be difficult if the inflation picture stays sticky, stubborn, and above the Fed’s 2 percent target. An additional crucial element will be the labor market, where the unemployment rate spiked to 4.3 percent in 2024 but may actually drop in 2025.
a declining unemployment rate and faster revenue growth.
According to some survey results, the labor market might even get better in 2025. There is a strong historical correlation between the unemployment rate and the NFIB poor sales index. After rising steadily until October 2024, the index fell precipitously in November, indicating that sales had improved.
The Consumer Conference Board Jobs Hard to Get index has also experienced a significant decline in recent months. This index has a strong correlation with the unemployment rate over time, indicating that unemployment is on the decline.
The NFIB data shows that hiring has improved as well, with hiring intentions recently increasing significantly. This index frequently serves as a precursor to the Job Openings Report (JOLTS).
The Indeed job posting date every week has also improved in the interim. In October, the Indeed index seems to have bottomed out, and the data point usually leads the JOLTS report.
In addition, wage growth seems to be picking up speed. After dropping to 3 to 6 percent in July, average hourly wages have now risen to 4 percent. On a three-month annualized growth rate, however, it rose to 4 points 5 percent after plunging to just 2 points 8 percent in April.
Additionally, there are indications of improvement in the NFIB compensation index and compensation plan index, which point to future planning for wage and compensation increases. Over time, there is a correlation between these two indexes and the average weekly earnings y/y index.
The aggregate weekly payrolls data, which indicate that an annualized 3-month rate of change accelerated to 5.8 percent through November, is another indicator of the strength of the labor market. This figure indicates that nominal GDP increased in the fourth quarter and tracks it over a longer time frame.
a 10-year rate of 6 percent.
Better GDP growth, reduced unemployment, and higher inflation rates also indicate that rates on the long end of the Treasury curve will probably keep rising, with the 10-year rate getting close to 6%. Generally speaking, the 10-year rate is around 300 basis points higher than the Fed Funds rate. Since the 10-year is currently only 20 basis points above the Fed Funds rate, it still has a lot of room to rise in front of it, so how high it rises will depend on where the Fed Funds rate moves.
There may be a chance for Fed hikes.
The market is now pricing out rate cuts in 2025, even though the FOMC’s most recent Summary of Economic Projections indicated two rate cuts. This could also be due to higher inflation, improved labor markets, and stronger growth. Less than two rate cuts are anticipated in 2025, according to Fed swaps, with the next one not occurring until June.
Rates may also increase over the next 12 to 18 months, according to 3-month T-bill interest rate forward contracts. Since the fall of 2022, the spreads between the forward and spot contracts have been inverted; they are now positive.
This suggests that the Fed’s cycle of rate-cutting is over and that a hike is the likely next course the Fed will take. Credit spreads will increase if this is true. This will play a significant role in the trading of risky assets in 2025. Risk assets saw a strong 2024 because credit spreads contracted despite sticky inflation, fewer rate cuts, and a rising unemployment rate, even though the economic outlook and the Fed’s plan for rate cuts in 2024 were accurate. The main reason for this was the high level of market expectations for rate cuts.
Greater Credit Spreads.
Today’s credit spreads, however, are extremely tight and, in certain situations, the tightest they have been in almost two decades. Since the Bloomberg High Yield OAS has dropped to its lowest point since 2007, it will likely be even harder for credit spreads to tighten and push riskier assets higher through multiple expansion in 2025.
More significantly, credit spreads and financial conditions are closely related. if there is a chance that the Fed will need to implement stricter guidelines in 2025. Financial conditions will tighten following a period of significant easing that began in the second half of 2023. As a result, the equity market saw a sharp increase and reached its highest valuations.
At 4,400, the S&P 500 will fall.
The S&P 500 will undoubtedly rank among the most costly of the modern era by the end of 2024; whether it is THE most costly is up for debate. The price-to-book, price-to-sales, price-to-earnings, and dividend yield ratios all rank the S&P 500 as one of the most costly markets.
Additionally, a 2024 surge in liquidity through leverage and margin has helped with this. Easy financial conditions and growing margin balances have combined to push valuation to some of its highest levels in decades and drive this market sharply higher.
The S&P 500’s P/E ratio may contract back to more historical norms, possibly returning to a median of 18.5, if mean reversion is engaged and financial conditions tighten due to fear of a Fed rate hike in 2025 because inflation remains sticky and the labor market improves. In that case, the S&P 500 would drop to 4,400 as the P/E would contract by about 26%.
In 2025, it appears likely that there will be many moving components once more, and nobody can predict what will happen in the end.
Best of luck!
