The Core CPI declined for the first time in six months, shifting expectations for rate cuts, pushing Treasury yields lower, and triggering a rally in risk assets.
The December results showed signs of inflation moderation. According to the Bureau of Labor Statistics, the CPI rose 0.4% Month over Month and 2.9% year over year. The core CPI (which excludes food and energy) increased 0.2% Month over Month and eased to 3.2% annually from 3.3% in November.
Energy prices surged 2.6% in December, driven by a 4.4% jump in gasoline, which accounted for 40% of the CPI’s monthly increase. Food prices rose 0.3%, contributing to a 2.5% annual gain. Shelter costs, making up one-third of the CPI, increased 0.3% MoM and 4.6% year-over-year, the smallest annual rise since January 2022. Fedspeak this weak leaned dovish, with officials expressing optimism about inflation trends and the potential for rate cuts, though Cleveland’s FED Hammack emphasized persistent inflation risks. Fed’s cautious, data-driven approach to rate adjustments remains a source of market concern.
With Donald Trump’s inauguration as the US President set for Monday, the market is preparing for changes in the White House. However, the market is currently pricing in a lot of political risk, as there is no clarity on how the changes will be implemented, how fast they will occur, or what they will be. Washington events provided little clarity on future Trump administration policies. Reports highlighted potential tariff strategies and Canada’s countermeasures. Senate confirmation hearings, including for Treasury nominee Scott Bessent, offered limited new details but reinforced the extension of tax cuts and the limited inflation impact of tariffs. Uncertainties about Trump’s policies elevated long-term yields.
The dollar has strengthened significantly and appears overbought, though its strong momentum suggests it could rise further. Moreover, the market has already priced in the possibility of aggressive policies from the Trump administration. In the 2016 election, Trump’s victory initially boosted the dollar significantly. However, the dollar’s strength peaked at the beginning of 2017 and steadily declined throughout the remainder of his term. If his first term is any indication, the dollar may be nearing its peak again.
The Chinese economy is struggling to grow quickly, facing its longest period of deflation since the 1990s. At the start of the year, Chinese government bonds hit record lows, with the 2-year bond touching 1% at the start of the year, though it has since recovered to over 1.2% in the past two weeks. These developments reflect recessionary expectations. With a current price decline of about 2%, the nominal yield on short-term government bonds, at just 1%, results in a 3% real yield. Price declines are driven by decelerating consumer demand and a contraction in broad credit. The aggregate financing stock and bank loan stock have rapidly declined in 2024. Additionally, there is a negative wealth effect due to the collapse of the real estate bubble in 2021, leading to significant cuts in spending by individuals and companies.
Another issue is that the majority of spending comes from local governments. For years, they have funded operations by selling land for real estate development projects. However, as the bubble collapsed, their revenue dried up, putting pressure on their ability to invest in economic growth.
The situation began with COVID-19 lockdowns, during which China imposed some of the harshest restrictions globally, causing demand to collapse. As demand disappeared, oversupply followed, prompting producers to cut prices in order to sell ageing inventory. Initially, buyers reduced their spending due to fears that COVID-19 would resurge, leading them to save more in preparation. As prices fell, some consumers delayed their purchasing decisions, hoping for further price declines, thus contributing to a deflationary spiral.
The slowdown in China’s Q3 2024 growth to 4.6%, compared to the 4.8% annual growth forecast for 2025, raises questions about the underlying economic dynamics. This gloomy outlook adds further pressure on Chinese equity valuations, which are already depressed.
Rates
Treasury yields decreased following the CPI report. On January 17, the 10-year note yield was 4.61%, down from 4.77% on January 10. This week, we also saw significant outperformance in the belly of the curve, with the U.S. Treasury fly (short 2Y and 10Y Treasuries, long 5Y Treasury) delivering its best two-day performance since July 2023. The 30-year yield briefly touched 5% earlier in the week before easing. The U.S. dollar weakened against the yen and euro but gained slightly against the pound, with the DXY index edging down by 0.3%.
The sell-off in Treasuries since September has been primarily driven by changes in the term premium. The rally on the long end of the curve has pushed the 10-year term premium to its highest level since 2015. However, the current 58 bps term premium remains at the lower end of its historical range. In addition to term premium concerns, the market is still focused on inflation, as seen this week when 10-year yields dropped by as much as 15 bps intraday following the reported decline in December CPI. Furthermore, the 2-year inflation swaps are now at the top of their two-year range, standing at 2.7%.
The market is concerned about changes in debt issuance, particularly the increased issuance of Treasury bonds at the longer end of the curve. Over the past two quarters, the majority of issuance has been concentrated at the front end. Treasury bills issuance has risen from 72% to 85%, while historically, it has been between 15% and 20% post-GFC. Meanwhile, 4-9 year Treasury issuance has declined from 9% to 4.5%, and 2-3 year issuance has dropped from 8.5% to 5%. This suggests a significant amount of Treasuries will need to be rolled over in the next 12 months. The market is beginning to price this in, with U.S. credit-default swaps rising from 35 bps in early December to 38.5 bps this week.
Most analysts expect the neutral rate for the economy to be around 4% to 4.5%, with a 75 to 100 bps term premium. This puts the 10Y expectation between 4.75% and 5.5%.
Current yield curves likely price in a gradual easing path. If central banks cut rates faster or deeper than expected, bond prices will rally due to falling yields. However, there is increased fear that the new administration’s plans will create more inflationary pressure and a larger budget deficit, potentially pushing yields even higher, especially on the longer end. Since most are positioned on one side of this trade, this could create an oversold condition later this year, presenting an opportunity for duration bets.
In 2025, the U.S. government will need to pay just over $3 trillion in principal and interest on Treasury bonds, which will increase to $3.4 trillion in 2026. Furthermore, there is little scope to reduce the projected budget deficit, which could add another $2 trillion. This could result in gross issuance of up to $5 trillion this year, or 17% of the U.S. GDP.
The last three years have seen the worst performance stretch in 180 years. Additionally, the rolling 10-year returns for long-term maturities (15 years or longer) are negative for the first time since the 1960s, marking the worst performance in 90 years.
Credit
IG issuance has surged this week, surpassing expectations and bringing the total weekly volume to USD 46B. This week’s issuance was mainly driven by the banks (10B BoA, 8B JPM, 8B MS, 6B Wells Fargo, and 3B Citi). A noticeable issue was Citadel, which raised $1B in high-grade bond issuance to fund the payout for its owners and achieved 10x coverage.
The “good yield, bad spread” environment continues. The spread reflects the strength of corporate credit and the continuous strength of the US economy. Higher yields are helping to attract capital to the asset class. At the same time, there is a risk related to higher default rates, which have been increasing over the past few years, although the bankruptcies are stable. The high-yield default rates are trending down, and the land default rates are also trending down.
Sectorwise, the cyclical sector has an attractive risk premium, which should offer a good opportunity given the new administration’s pro-growth stance. We also see growing demand in the credit loan market. What attracts investors is that loan defaults are mainly processed through restructurings, resulting in higher recovery ratios than bankruptcies. Therefore, the losses are much lower than what default rates would imply.
Equities
U.S. equity markets rebounded strongly this week, with major indices posting gains after two weeks of declines. The S&P 500 and Nasdaq both climbed, bolstered by a broad-based rally. With notable breadth improvements and the S&P 500 back above its 50 DMA, we are set for a short-term rally. Equal-weighted indices outperformed, with the RSP up 3.9%. Notable sector performance included gains in banks, asset managers, credit cards, homebuilders, energy, machinery, chemicals, and utilities, while pharma, biotech, airlines, and retailers lagged. Top performing sectors were Energy +6.14%, Financials +6.10%, Materials +6.01%, Real Estate +4.84%, Industrials +4.82% and Utilities +4.27%.
Big tech contributed to the rally, with Tesla surging 8.1%. Banks were a standout following better-than-expected Q4 earnings, with Citigroup (+12%), Morgan Stanley (+11.7%), and JPMorgan (+8.2%) leading the charge. Positive early results, especially from big banks, add optimism, underpinned by strong 2025 NII guidance. Other corporate highlights included Intel (+12.2%), boosted by M&A speculation, and United Rentals (+14.9%), announcing an acquisition of HEES (+100.6%).
Bullish sentiment was supported by signs of disinflation, lower Treasury yields, and positive Q4 earnings. Improved market breadth also reduced concerns about concentration in the Mag-7 stocks. However, lingering uncertainties around fiscal policies and elevated longer-term yields tempered optimism, highlighting the market’s cautious outlook.
The overall outlook suggests caution. Valuations remain elevated, and optimism is high. Based on cumulative retail fund flows, we are now in the ‘hype’ phase. However, brokerage house analysts’ surveys show that institutional demand for equities is declining and are becoming less bullish. Historical patterns also suggest that after two years of strong back-to-back gains, there is more resistance in the third year of the rally.
Since the election, there has been an interesting pattern in fund flows. We have seen inflows into growth, small caps, value, technology, and financials, signalling optimism about the US economy. We also saw outflows from international equities, especially China and Europe, reflecting potential headwinds from tariffs and other America First policies. Another noticeable item is outflows from long-duration bonds, as the market is anxious about the fiscal deficit.
Next week, the equity market focus will shift to the accelerating Q4 earnings season, with 43 S&P 500 companies reporting. Economic data will be lighter, highlighted by Friday’s January PMI composite. The Fed enters a blackout period ahead of the January 29 FOMC meeting, and U.S. markets will close Monday for MLK Day. Trump’s inauguration on Monday is expected to draw attention, with potential executive orders on tariffs, immigration, deregulation, and energy anticipated. Markets maintain some optimism regarding upcoming policies but remain cautious about potential volatility from executive orders.