Think the Stock Market Will Soar Again in 2025? The Bond Market Could Be Signaling Otherwise.

The optimism on Wall Street is palpable, with many analysts predicting that the S&P 500 (SNPINDEX: ^GSPC) may continue to show strong performance this year, following a remarkable 23% increase last year. Factors such as advances in artificial intelligence (AI) and the potential for corporate tax cuts and reduced regulations under a possible second Trump administration are seen as contributing elements toward this positive outlook.

However, the question arises: is the stock market really set to rally once more in 2025? The bond market might be hinting at a different story.

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Interest Rates and Rising Yields

Typically, bond yields and interest rates are closely linked, particularly for short-term bonds. When interest rates rise, newly issued bonds generally offer lower coupon rates, which mirrors the decrease in borrowing costs. This makes existing bonds with higher yields more appealing, leading to increased demand that drives up their prices and in turn lowers their yields. Conversely, when interest rates drop, bond yields usually decline as well.

This pattern was observable when the Federal Reserve (Fed) began its aggressive interest rate hikes in 2022 and 2023, which naturally resulted in higher bond yields.

In September 2024, however, the situation changed as the Fed made its first interest rate cut in four years and continued with subsequent cuts in November and December. Many investors assumed that this would result in a decrease in bond yields.

Interestingly, the U.S. 10-year Treasury yield, often seen as a benchmark for many loans, did not follow this expected trend. Instead of falling, this important yield actually increased.

Data source: YCharts.

Potential Warnings for the Stock Market

What might explain the rise in the U.S. 10-year Treasury yield in the face of interest rate cuts? Bond investors consider a variety of factors beyond just interest rates, and there may be concerns about the future economic environment.

One significant fear is that inflation may suddenly spike again. A second Trump administration might impose steep universal tariffs, potentially reaching 20% on various imports, which could trigger inflationary pressures. Added to this, plans for large corporate tax cuts and strict immigration regulations might also contribute to rising inflation.

Higher inflation generally poses challenges for stocks, as shifting consumer behavior may lead to decreased spending, which in turn impacts the sales and profits of retailers.

Moreover, a return of inflation would likely halt further interest rate cuts from the Fed. In fact, indications point to the possibility of fewer rate adjustments than previously expected in 2025. This implies that the bond market is reflecting fears that interest rates might remain elevated, limiting any continued upward momentum in the stock market.

Additionally, there is a less evident warning sign emerging from the bond market: the earnings yield of the S&P 500 is currently at its lowest level compared to U.S. Treasury yields since 2002. Furthermore, there is a notable gap between this earnings yield and that of BBB-rated corporate bonds. Both factors suggest a historically pricey stock market that could be vulnerable if any significant challenges arise.

Investment Strategies

If you focus on generating income, the current situation may actually work to your advantage. Increased bond yields could improve your income prospects, and should stocks decline, it will create opportunities to invest at more favorable valuations with appealing dividend yields.

For other investors, a good approach is to maintain a long-term perspective.

The bond market may be issuing a cautionary note regarding the stock market's near-term performance. However, such signals do not necessarily predict the next five to ten years. History shows that, over the long haul, stocks tend to perform well.

That said, it might be prudent for investors to pay extra attention to valuations and growth prospects, especially during times when the bond market appears unsettled. If the stock market does experience a sharp pullback, holding stocks that are already reasonably priced can be beneficial. And if the bond market's apprehensions prove unfounded, you will still have stocks with significant potential for growth.

Keith Speights has no position in any of the stocks mentioned. The article does not indicate any affiliation with the companies discussed.

Stocks, Bonds, Market