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The bulls continue to run rampant on Wall Street. Most analysts believe the S&P 500 (SNPINDEX: ^GSPC) will deliver strong gains again this year, after jumping 23% in 2024. Some point to investment in artificial intelligence (AI) and the potential for corporate tax cuts and deregulation in a second Trump administration as likely tailwinds.
But will the stock market really soar again in 2025? The bond market could be signaling otherwise.
Rising yields despite rate cuts
Ordinarily, there is a direct correlation between interest rates and bond yields, especially the yields of short-term bonds. When rates rise, newly issued bonds typically offer lower coupon rates, reflecting lower borrowing costs. Existing bonds with higher yields become more attractive than newer bonds. This increased demand causes their prices to rise, pushing their yields down, since the yield is the bonds' fixed coupon payment divided by its price. When interest rates decline, bond yields usually do too.
The latter scenario played out when the Federal Reserve began aggressively raising interest rates in 2022 and 2023. Bond yields rose as rates increased.
In September 2024, the Fed cut interest rates for the first time in four years. It followed up with rate cuts in November and December. Many investors might have naturally assumed that bond yields would fall, too.
However, an interesting thing happened with the U.S. 10-year Treasury yield, which is used as a benchmark for many loans. Instead of declining as interest rates fell, this widely followed yield has risen.
A potential warning signal for stocks
Why would the U.S. 10-year Treasury yield rise as the Fed cut interest rates? Bond investors look at several other factors in addition to interest rates. And they could appear to be concerned about potential trouble on the horizon.
Perhaps the biggest worry is that inflation could roar back. A second Trump administration could impose steep universal tariffs of up to 20%, and even higher tariffs on products imported from some countries, which many economists predict will lead to higher inflation. The prospects of major corporate tax cuts and mass deportations of undocumented immigrants could also be inflationary.
Higher inflation wouldn't be good news for many stocks. For example, consumers are less likely to spend when prices are higher. This negatively impacts the sales and profits of retailers.
The Fed would also almost certainly halt any further interest rate cuts with resurging inflation. It has already hinted that fewer rate cuts than initially anticipated will be made in 2025. The bond market could reflect fears that interest rates won't be reduced from current levels at all. The stock market's momentum might not be able to continue if no more rate cuts are in store.