The normal

After Santa Claus failed to rally, January, so far, has been no better. In 42 of 59 years since 1965, January and the year as a whole rose or fell together. (Quite decent odds.) The S&P 500 is not very far from all-time highs, but internals of the market tell a different story, with just 9% of the index in an uptrend while 68% is in a downtrend. Falling bull/bear ratios in recent weeks, a contrary indicator, could be bullish though. Emerging markets have struggled, with the currency of commodity-exporting countries suffering from weak demand in China and Europe. US bond yields push ever higher, but so far BBB spreads remain tight, suggesting the equity bull market is intact.  Still, yields above 4.5% have spelled trouble for the market in the recent past. A three-peat of 20% gains for the S&P 500 would require a strong economy and falling inflation. Jerome Powell has been fortunate thus far and that (well, that and AI) has been the secret to a market and an economy that keep surprising upwards. But lately weak market breadth and fears of bond yields give cause for patience, especially since the often-weak month of February lies before us. Volatility is likely to be elevated for some time, as pro-growth forces, such as AI and deregulation, battle it out with inflationary forces such as tariffs and immigration restrictions. At this point, the bond market is bossing the stock market around, with tighter correlations between interest rates and American Association of Individual Investors (AAII) equity sentiment than between the S&P 500 itself and AAII equity sentiment. 

And the bond vigilantes are bossing the bond market. The Fed cut rates last autumn even though inflation is not quite at “target” and the economy is strong. This has brought a return of the “bond vigilantes.” The 10-year yield is up over 100 bps since the Fed began cutting rates in September, while the fed funds rate is 100 bps lower since then. This is the most that 10-year yields have risen during an easing cycle since 1981, when Paul Volcker was at work. The expression “bond vigilante,” coined by Ed Yardeni in the 1980s, refers to traders who bet that inflationary policies will cause a country’s bond yields to rise. This is not just a US problem. There have been signs of disruption in the UK, where gilt yields have surged to pre-GFC levels. So far, the US Treasury has not been faced with a dreaded “failed auction” or other form of bond buyers’ strike. This is why it is important for Scott Bessent, Trump’s nominee as Treasury secretary, to get deficits as a percentage of GDP under control. (Good luck with your 3-3-3- plan, Scott.) Yields have risen here, whether from tariff angst, deficit worries, high levels of Treasury supply, a strong labor market or all the above. Last year, the equity market enjoyed stellar performance while the 10-year yield jumped about 70 basis points; similar divergences between stocks and rates were seen during the late 1990s. Rate sensitivity is not evenly distributed, anyway. Large companies (just like affluent homeowners) mostly enjoy low, long-term rates locked in before the yield spike. It is more smaller caps, private equity, commercial real estate and, yes, the Federal government itself that face the full force of higher rates. But how insulated can even large caps be from an increase in rates when stocks are nearly their most expensive versus bonds in two decades?

For now, equity markets are, however unwillingly, digesting this rise in yields, which started in mid-September. As to bonds, all that’s really happened, so far, is that bond yields have gone back to normal. The era of abnormal ultralow rates brought on by the Global Financial Crisis is over. Yields have risen because of a strong economy, and stocks can coexist with higher rates (to a point) for the very same reason. If the employment cost index (which tends to follow the quits rate, currently at a cycle low) soon slows to 3% y/y, unit labor costs should be fine. When the ISM Services report came in strong this week, expectations for Fed rate cuts this year fell from two to just one. (Following Fed rate cut expectations is dizzying!) In the wake of the GFC, bond investor Bill Gross coined the expression “the new normal” to refer to the low-rate post-GFC world. That time has gone. As yield curves re-establish themselves, it feels much closer to just plain normal. “The normal.” Strap yourselves in; next week is CPI …

Positives

• The Fed will see no need to rush Payrolls surprised in December for the forty-eighth straight month, the second longest streak in 85 years, adding 256K jobs while the unemployment rate fell to 4.1%. Expectations were for 160K and 4.2%, respectively. Average hourly earnings rose at a 3.9% y/y rate. It does appear that recoveries from hurricanes and the end of the Boeing strike account for much of the upside surprise.
• Quits rate says lowflation The JOLTS report showed a decline in the private sector quits rate to 1.9%, the lowest level this cycle, which will keep wage growth muted. Job openings grew but the ratio of openings per worker is 1.13, below the pre-pandemic level. Further, professional and business services accounted for all the 3.3% increase in November openings from the prior month.
• ISM says reflation The ISM Services survey rose to 54.1 in December from 52.1. However, the prices paid subindex rose to its highest level in nearly two years, with 15 of 18 industries reporting an increase in prices paid. Many respondents mentioned concerns about tariffs, possibly suggesting that firms raised prices in fear of a tariff hit to their supply chains. 

Negatives

• The consumer says inflation The University of Michigan’s consumer sentiment index fell to 73.2 from 74 versus expectations of 73.3. Of more concern, inflation expectations rose sharply, with respondents in January expecting year-ahead inflation of 3.3% versus 2.8% in December and long-term inflation expectations of 3.3% versus 3% in December.
• Housing remains the fly in the ointment Mortgage demand is very soft. Mortgage applications fell 6.6% for the week ending January 3, the victim of 30-year mortgages at 7%. This was the fourth drop out of the last five weeks, placing applications at their lowest since 2011. 
• Trade imbalance The trade deficit grew by $4.6 billion in November to $78.2 billion, as import growth exceeded the growth of exports. Imports rose $11.6 billion but this followed a $13.9 billion decline in October. The volatility may be a function of the brief East Coast ports labor action. 

What Else

Maybe it’ll all be OK Fed members’ minutes make clear their worries that Trump’s new tariffs and immigration policies will have deleterious macro effects. That could be, but experience suggests the Fed should be cautious of its own caution. The tariffs from the first Trump administration did not have strong effects on inflation, the dollar or growth.

A Congress of elders The new Congress (our 119th) is the third-oldest ever, with an average age of 58.9 years. Perhaps unsurprisingly, the Senate (which comes from the Latin word for old man) is older as a group, with an average age of 63.8 versus the House’s 57.7. The only Congresses older than the current one were those that began in 2017 and 2021.

Perhaps AI can come up with something new Of the top 10 highest-grossing movies last year, nine were sequels. The outlier, an exception that proves the rule, was Wicked, which is based on The Wizard of Oz. Perhaps it’s a miracle that nonsequels even get made if the hits are mostly all sequels.