The Market’s Rocky Reality

The financial markets are navigating rocky waters as a confluence of unexpected economic data and diverging policy expectations create uncertainty, sending investors for fixed income rather than risk. Despite the Fed’s recent rate cuts in Q4, aimed at stabilising growth and containing inflation, the economy is sending mixed signals and is pushing back hard, with bond yields rocketing and risk markets under pressure.

At the heart of this storm lies a fundamental question: Does the Fed still have the market’s trust? I am not so certain! December’s job gains defied expectations, inflation remains stubbornly persistent, and the bond market is signalling that the Fed’s narrative is losing traction. Instead of rallying behind the central bank, markets are charting their own course which is a rare and seldomly chartered dynamic!

With the CPI and PPI inflation prints due this coming week and the risk of higher-for-longer rates likely to be the outcome of the next Federal Open Market Committee (FOMC) meeting on the 29th of Jan, the stakes couldn’t be higher. The Fed is facing a credibility crisis that could undermine the effectiveness of its policies, heightening risks for financial markets at a time of significant uncertainty.

In this newsletter, we’ll unpack the latest jobs data, explore the bond market’s rebellion, and examine what’s at stake for the Fed, investors, and the broader economy… expanding on a few of the catalysts we discussed in last week's newsletter: Global Catalysts that will Rewrite the Rules in 2025!

Strong Jobs Data Challenges the Fed's Narrative

The December jobs report, released last Friday, has introduced complexities into the Fed’s policy landscape. The U.S. economy added 256,000 jobs in December, surpassing forecasts of around 160,000. This solid job growth led to a drop in the unemployment rate to 4.1%, suggesting a resilient labour market. This sounds great, right? But in the current economic climate, good news is bad news!

This strong employment data challenges the Fed’s recent monetary policy stance. The Fed had reduced the Federal Funds Rate by 1% since September 2024, citing slowing job gains and a trajectory toward their 2% inflation target as justification. However, the December jobs report contradicts these claims, indicating a robust labour market. This raises concerns about potential inflationary pressures, as sustained job growth and wage increases can lead to higher consumer spending, potentially driving up prices.

In response to the strong jobs data, market expectations regarding the Fed’s future policy actions have shifted. Investors are now pricing in the possibility that the Fed may pause its rate-cutting cycle or even consider rate hikes in 2025 to prevent the economy from overheating. This shift is reflected in the bond markets, where the 10-year Treasury yield has risen from 3.6% to 4.77%, indicating that investors anticipate higher interest rates.

In short, the strong December jobs report challenges the Federal Reserve's recent policy stance and raises questions about its future actions. The robust labour market suggests the economy may not be slowing as anticipated, leading to potential inflationary pressures. This has caused markets to rebalance their expectations, with implications for bond yields and the Fed's credibility.

Bond Market’s defy the Fed.

Despite the Fed cutting the Federal Funds Rate by 1% since September, bond markets are telling a different story. The yield on the 10-year U.S. Treasury has surged to 4.79%, its highest level this year. Historically, rate cuts lower yields as markets align with central bank policy. This time, however, the divergence suggests growing investor scepticism about the Fed’s ability to steer the economy. Bank of America has revised its forecast, now predicting potential rate hikes in 2025.

As I emphasised in last week’s newsletter, bond markets are a critical catalyst for risk markets this year. The 10-year Treasury is at the centre of this dynamic, with rising yields acting as both a signal and a driver of broader economic shifts. This steep rise in yields is part of a bear-steepening yield curve, where long-term rates rise faster than short-term ones. This pattern reflects a market bracing for inflationary pressures, persistent economic resilience, and the possibility that the Fed may maintain or even increase rates to combat inflation. December’s surprising jobs report added fuel to this fire… Bond markets are responding by pricing in higher inflation expectations and increasing term premiums, as investors demand greater compensation for the risks of holding longer-term debt.

Higher bond yields make fixed income more appealing relative to equities, prompting capital outflows from riskier assets like stocks or crypto into the perceived safety of bonds. This dynamic is pressuring equity markets, particularly interest-rate-sensitive sectors like technology and real estate. Higher yields also mean increased borrowing costs for governments and corporations, potentially straining budgets and investment plans.

As we discussed last week, the bond market is a force capable of reshaping financial markets in 2025. The 10-year Treasury yield serves as a critical benchmark for everything from mortgage rates to corporate debt, and its continued rise signals a repricing of risk. For investors, this means navigating a market where volatility could persist as bonds challenge the Fed’s credibility and risk markets to adjust to tighter financial conditions. With the FOMC meeting on the 29th of January and inflation prints this week, all eyes will be watching the bond market. The movements of the bond market will shape how markets price risk, adjust economic forecasts, and interpret the Fed’s ability to balance growth with inflation control.

We have to pay close attention to the CPI and PPI prints this week. Current market expectations are as follows:

Producer Price Index (PPI):

• Month-over-Month (MoM): A 0.3% rise is expected for December 2024.

• Year-over-Year (YoY): While less specific, YoY figures are expected to show modest growth or stabilisation, in line with the MoM trend.

Consumer Price Index (CPI):

• Month-over-Month (MoM): Projections range from a 0.2% to 0.3% increase, though Goldman Sachs forecasts a higher 0.4% rise for headline CPI.

• Year-over-Year (YoY): Headline CPI is expected to climb to 2.9%, with core CPI, excluding food and energy, growing approximately 3.27% YoY.

When assessing the impact of this data on risk, it's essential to focus on market reactions. How the market interprets and responds to the numbers will be just as important as the figures themselves. Suppose the inflation data aligns closely with forecasts. In that case, markets may remain stable and consolidate before the next leg up, but any significant surprise… whether much higher or lower than expected, could trigger heightened volatility. Such surprises can lead to rapid repricing across asset classes.

Big Week for Risk!

Why the Fed’s credibility matters

The credibility of the Fed is crucial for keeping the peace in the economy. The Fed primarily influences the economy by adjusting short-term interest rates. But for its actions to be effective, the market needs to trust that the Fed is making the right moves. If the market believes the Fed is managing inflation well, its policy decisions are more likely to succeed. However, when there’s a disconnect between the Fed’s outlook and what the market expects, like when long-term yields rise despite rate cuts, its power diminishes. This disconnect signals that investors no longer believe the Fed can control inflation or navigate the economy successfully, which weakens its influence.

How bad can a loss of credibility be? Short answer… its bad! A loss of credibility impacts borrowing costs, as investors demand higher yields on bonds to compensate for perceived risks when they doubt the Fed's ability to control inflation. This drives up borrowing costs for businesses and consumers, which can reduce investment and spending, slowing economic growth. Higher borrowing costs are especially harmful for businesses relying on affordable financing to expand, potentially stunting job creation and wage growth. Moreover, Fed credibility is crucial for anchoring inflation expectations. If the public believes the Fed will maintain price stability, inflation remains in check. However, when credibility falters due to mixed messages or policy missteps, inflation expectations can rise, triggering a vicious cycle of higher inflation that becomes more difficult for the Fed to control.

So when the Fed is credible, it provides a sense of stability, which encourages investment, job creation, and consumer confidence. If the market loses trust in the Fed, uncertainty creeps in, making the economic environment less predictable. This instability leads to greater volatility in financial markets, often causing downside pressure on risk markets which is exactly what we are seeing right now! Without trust, businesses and consumers become more cautious.

The Fed’s credibility is key to managing the economy effectively. For the central bank to continue guiding the economy in the right direction, it must maintain a clear, consistent message and work to restore any lost confidence. This puts significant pressure on the next FOMC meeting, the first of 2025, just after Trump assumes the presidency. All eyes will be on how the Fed navigates this event.

Can Trump’s inauguration save the day?

The biggest question on everyone's mind is: Can Trump save the day? As crypto enthusiasts and equities traders, we like to believe so, especially when we’re all hoping “numbers go up.” But let’s dive deeper and examine whether the optimism surrounding his return to office is justified or if broader concerns should be weighing on our minds.

Let’s start with the positives. Trump’s inauguration will likely provide some needed clarity, particularly when it comes to his economic agenda. If his administration moves quickly to implement policies like tax cuts, deregulation, or infrastructure spending, it could give a short-term boost to the economy, potentially alleviating some of the concerns currently driving market volatility. These policies have historically been seen as positive for business sentiment, and investors could react favourably to a business-friendly environment. A "Trump trade" rally might even spark a short-term rally in equities, as some believe his policies will stimulate growth, particularly if they focus on deregulation and tax cuts for corporations and individuals.

However, it’s not all sunshine and rainbows. There are several significant downsides to consider, especially as inflation remains persistent. Trump's fiscal policies, particularly the focus on tariffs, could exacerbate inflation. Tariffs act like hidden taxes on consumer goods, raising prices and potentially fuelling inflation further. This could complicate things for the Fed, which might be forced to keep rates higher than anticipated, stifling the very economic growth Trump might be trying to encourage. We could end up in a situation where the positive effects of fiscal stimulus are muted by rising inflation, making the Fed’s job harder and limiting the impact of any pro-growth measures from Trump.

Further complicating matters, Trump’s economic policies, particularly around trade and immigration, have historically created significant market volatility. The trade wars and unpredictable policy announcements during his previous term rattled markets and kept investors on edge. We could see a repeat of this, with rising uncertainty about how policies will be implemented. The risk of global trade disruptions, especially if other countries retaliate against tariffs or protective trade measures, could add even more volatility to already shaky markets.

Another key issue, as we discussed earlier, is once again the Fed’s credibility. Trump’s past criticisms of the Fed’s actions, particularly its interest rate policies, are unlikely to disappear. If Trump continues to exert pressure on the Fed, it could undermine its independence and exacerbate market uncertainty. Investors could begin to question the Fed’s ability to act decisively and in the best interests of the economy, leading to an erosion of trust in U.S. monetary policy.

Of course, all these policies could have an impact on crypto markets too. On the one hand, Trump has shown support for the crypto sector, which could foster a more favourable regulatory environment. If that happens, crypto could benefit, especially as an alternative investment or inflation hedge. However, if the broader market suffers from rising inflation and higher interest rates, crypto could struggle just like other risk assets.

The ultimate question remains: Can Trump “save the day”? The answer isn’t clear-cut. In my opinion, while there’s certainly potential for short-term rallies, especially if markets respond positively to policy announcements, the longer-term impact is much more uncertain. The success of Trump’s economic strategies will depend heavily on their implementation and their interaction with existing inflationary pressures, high interest rates, and global trade dynamics. The risks are significant, particularly when it comes to inflation, market volatility, and potential trade disruptions, all of which could undermine the broader economic stability.

In short, while Trump’s policies could offer a short-term boost to risk markets, including equities and crypto, the broader implications remain uncertain. His economic agenda may stimulate growth initially, but it could also fuel inflation and increase uncertainty. However, looking at past inauguration events, we’ve seen strong rallies in risk assets, so the short term could bring a wild ride!

Critical Weeks ahead

The remainder of January is honestly the most critical period for financial markets, with several key events on the horizon that will influence the outlook for the rest of 2025. As the Fed faces a growing credibility crisis, the coming weeks will provide crucial data points to gauge both the short-term market potential and the broader macroeconomic implications. The January FOMC meeting, the release of inflation data, and the inauguration of Trump all stand as critical points that will influence the trajectory of the global economy for the year ahead.

As traders and investors we have to pay close attention to these developments, as they will set the tone for market expectations and central bank strategies moving forward.

Key Takeaways:

1. Credibility Crisis at the Fed: The Federal Reserve's credibility is under scrutiny as strong labour market data challenges its narrative, leading to diverging expectations for monetary policy and higher bond yields.

2. Bond Market’s Rising Skepticism: Bond yields have surged, signalling market doubts about the Fed’s ability to control inflation and navigate the economy. Investors are recalibrating expectations for interest rates and inflation, adding to market volatility and challenging risk assets like equities and crypto.

3. Inflation Data and the FOMC: The CPI and PPI inflation prints set to be released in the coming week, along with the FOMC’s decisions at the end of the month, are critical in shaping market reactions. Any surprises in inflation data could trigger significant shifts in asset prices and expectations for monetary policy.

4. Trump’s Inauguration and Economic Uncertainty: Donald Trump's return to office brings both opportunities and risks. His policies could offer short-term economic boosts, but their long-term impact, particularly on inflation and global trade, remains uncertain. Markets will have to navigate the delicate balance between potential growth and the risks of exacerbating inflationary pressures.

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