If the stock market is going to duplicate its stellar 2024 performance next year, it will have to overcome a familiar foe in the form of stubbornly high bond yields. After entering a five-month swoon in April, Treasury yields have been on a tear since mid-September as traders repriced fixed-income dynamics. The 10-year Treasury yield, considered a bond market benchmark, was up a full percentage point from its September low heading into Monday trading, when it moved lower . A multitude of factors have been cited as potential reasons for the spike: fears that inflation could reignite, confidence in a continued economic expansion and a growing likelihood that the Federal Reserve’s rate-cutting path will be considerably shallower than originally thought. US10Y YTD line 10-year yield movement Along with the move has come a jump in term premium , or the extra yield investors demand for the risk of holding fixed income. After declining into early December, the term premium is now at its highest level in about 2½ years. The most recent leg up is a direct result of anticipation that the Fed likely will not be as accommodating in 2025 following a full percentage point cut in benchmark borrowing rates since September, according to Michael Darda, chief economist and macrostrategist at Roth Capital Partners. Traders in the fed funds futures market are pricing in just two quarter-percentage-point Fed cuts in 2025. “We believe this spike in real rates/term premia is due to the volatility and uncertainty associated with year-ahead Fed policy rate expectations, which have exploded upward by 109 bps since mid-September,” Darda said in a Sunday note. “A slower Fed rate-cutting path along with a repricing of the terminal policy rate in an upward direction at a time when supply-side cross currents are set to intensify could set the stage for higher-risk asset volatility in 2025.” Even with yields rising, Roth is advising clients to add longer-dated Treasurys and buy defensive stocks that are sensitive to interest rates “given the sell-off at the long end of the curve.” Though there has been some angst in markets about the direction of inflation , which has moved little in recent months, Darda said disinflationary trends look to still be in place. There also are some signs of slowing in the U.S. economy even though the Atlanta Fed is tracking fourth-quarter GDP growth at a 3.1% annualized pace. The Citi Economic Surprise Index has been trending sharply lower in recent weeks, indicating that forecasters are overestimating the pace of growth. For Darda, the trends add up to a good place for investors to be cautious, following a 23% gain in the S & P 500 this year. “Sky-high-risk asset valuations suggest investor enthusiasm has reached levels that may be difficult to sustain,” he said. “We would hedge the risk of higher volatility with a barbell strategy with bonds and rate-sensitive, defensive sectors on one side and value stocks/sectors with low cyclical-adjusted valuations on the other.”
Why bond yields are signaling trouble ahead for the stock market