Will Risk Assets Continue to Decline?

The landscape of financial markets has experienced a notable shift recently, as risk assets including U.Sstocks undergo a significant correctionAfter a period of promising gains following November 5, the upward momentum has now been almost entirely erasedThe primary driver behind this downturn appears to be the steep increase in U.STreasury yields, which have drawn attention and raised concerns among investors.

Amid this backdrop, several key economic indicators from the United States highlight that the economy remains resilient, albeit under duress from rising costs and shifting monetary policyThe Markit Services Purchasing Managers' Index (PMI) for December recorded its highest level in 33 months, a sign that the services sector is maintaining strong activityMoreover, the Institute for Supply Management (ISM) services PMI also exceeded expectations, landing at 54.1, indicating expansion as well.

However, it is crucial to note that the price indices within these PMIs painted a less rosy picture

Specifically, the ISM services PMI saw a sharp increase of 6.2 points in the prices paid for raw materials and services, soaring to a troubling 64.4. This level is notable as it represents the highest point since early 2023, indicating that service industries are beginning to grapple with significant cost pressures.

In the labor market, compelling data has emerged from the U.SBureau of Labor Statistics, revealing that non-farm payrolls expanded by an impressive 256,000 jobs in December 2024—the largest increase in nine monthsThis figure notably surpassed market expectations, which were set at 165,000, and exceeded the conservative predictions from many economistsThis buoyancy in job creation is a clear sign of a labor market that remains vibrant and robust, with the unemployment rate dipping to 4.1%, also better than expected and down from the previous month.

Yet, the financial environment remains complicated

Since September of the previous year, the Federal Reserve has implemented a series of rate cuts totaling 100 basis pointsUnder normal circumstances, such measures might lower bond yieldsIn a counterintuitive twist, however, yields on 10-year U.STreasuries have risen by approximately 100 basis points during this same timeframeThis unexpected rise has been attributed largely to market anxieties surrounding rising inflation, pushing investors to seek higher bond yields as a hedge against potential risks.

Last week’s employment data exacerbated these inflation fearsThe imposing non-farm payrolls number thrust inflation concerns back into the spotlight, leading many to recognize it as the “elephant in the room” that cannot be ignoredThis has led to revised predictions on the timing of future rate cuts from the Federal Reserve; initial projections of potentially four rate cuts in 2025 have now drastically reduced to expectations of only one

Investors and analysts alike have begun to doubt whether further rate reductions will even take place, underscoring a pervasive sense of uncertainty in the market.

As we look ahead, the Federal Reserve faces a tough choice: maintain the current policy stance, or resume interest rate cutsIf the latter occurs, it is likely that market participants would anticipate further cuts in swift successionConversely, a decision not to lower rates could lead to a scenario where the market struggles to reconcile its expectations with realityThe current climate is riddled with uncertainty, as evidenced by the volatility surrounding the short-end yield of 2-year Treasuries, which has become difficult to assess within any definable value range.

Interestingly, the dynamic for long-term bonds has shifted slightlyWith the rising yield environment, the carry has turned positive, suggesting that long-term debt may appear to have a better safety margin compared to short-term bonds

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However, this supposed safety net does not necessarily translate to confidence, as questions linger regarding the sustainability of these trends due to inflation concerns.

It is important to note that the uncertainty emerging from macroeconomic factors is gradually permeating the stock market landscape as wellInvestors remain cautious; if fears of renewed inflation persist, any solace taken from recent bullish trends in equity markets may prove to be short-livedThe forthcoming decisions on tariffs and immigration policy, intertwined with economic data evaluations, will take months to fully unfold, and given that the Fed is almost certain to pause rate cuts in January, clarity in direction may not be established until the anticipated FOMC meeting in March.

In conclusion, while the reports from the labor market suggest resilience and vibrancy within the U.Seconomy, the specter of inflation continues to loom large