Schwab Market Perspective: Markets vs. Economy

The U.S. stock market has responded weakly to recent strong economic data—the same data that sparked a surge in Treasury yields—as investors consider future growth and reassess the potential for Federal Reserve rate cuts. Meanwhile, the possibility of a Bank of Japan rate hike in January has some investors wondering whether there could be another unwinding of the yen carry trade, an event that caused global market volatility last summer.

U.S. stocks and economy: Stocks vs. the economy

The U.S. labor market ended 2024 on a strong note, with a net 256,000 jobs created in December, a move down in the unemployment rate (to 4.1% from 4.2%), and an increase in the prime-age employment-population ratio (the percentage of people aged 25–54 who are employed versus the total working-age population). Hiring breadth—the net share of industries adding jobs—remained healthy and wage growth was firm, underscoring that at the aggregate level, the labor market was not flashing a recessionary signal by the end of the year.

However, as we pointed out throughout 2024, there were several cracks under the surface that started to show increasingly worrisome signs for labor. One of those was the growth in full-time employment, which (in year-over-year terms) slipped into negative territory in the beginning of the year, thus flashing a classic recession warning. However, as you can see in the chart below, the trend flipped positive in December.

Back to (full-time) work

It's one of the many dynamics—including an unusually stable unemployment rate—that has been unique to this cycle. In a typical cycle, a decline in full-time employment is consistent with a broad-based recession; so far, that hasn't been the case this time around.

While that is cause for celebration, the stock market hasn't responded in a kind way. The strong jobs report helped send Treasury bond yields higher, which coincided with a weak response for stocks. As shown in the chart below, the rolling 30-day correlation between the 10-year Treasury yield and the S&P 500^® index has fallen back into negative territory. All else being equal, that means bond yields have been rising for the "wrong" reasons (i.e., inflation concerns), which has put downward pressure on stocks.

Stocks and bonds not getting along

While the pullback for the S&P 500 has been mild thus far (in percentage change terms), there has been a much stronger hit to breadth. As shown in the chart below, the percentage of members of the S&P 500 index trading above their 50-day moving average has fallen sharply over the past month to a new one-year low.

2025 starts with bad breadth

For now, the market's longer-term breadth—the percentage of members trading above their 200-day moving average—hasn't been hit as hard. There might still be some downside, which wouldn't necessarily end the bull market, and if further weakness does unfold, we'd keep a close eye on the recovery in breadth. If the market resumes its trek toward new all-time highs without a commensurate improvement in underlying strength, the likelihood of a protracted drawdown would rise.

Fixed income: Treasury yields jump as Fed expectations change

Treasury yields continue to surge as strong economic growth, stalled inflation, and uncertainty about fiscal policy in the long run have shifted expectations about how much more easing by the Federal Reserve is likely (remember that yields move inversely to prices). Over the past six months, the market has gone from pricing in four to five rate cuts (or 100 to 125 basis points) in the federal funds rate this year to pricing in just one.

Markets are pricing in only one rate cut

Treasury yields have risen by more than 100 basis points, or 1%, in just four months, with 10-year yields coming close to 5%, a level reached only once since 2007. We expect that yields will continue to move higher in the near term, as long as the economy looks to be on solid ground and there is policy uncertainty on the horizon.

Treasury yields have neared 5%

On the positive side, the market has gone a long way toward discounting the uncertainties ahead. Real interest rates—adjusted for inflation—are at the highest levels in 15 years and consistent with ongoing strength in the economy.

Real interest rates are at the highest levels in 15 years

In addition, the term premium—the extra yield investors demand to hold longer-term bonds versus reinvesting in short-term bonds—has moved up sharply in the past few months. After a long stretch in negative territory, the term premium has moved up sharply. It's now positive by about more than 60 basis points for 10-year Treasuries. It could still move higher based on past history, but its rapid rise indicates that much of the uncertainty about the outlook for Fed policy has been discounted.

As a result of the relative strength of the U.S. economy compared to other major developed countries and divergence in interest rates, the value of the U.S. dollar has been rising sharply. On a broad trade-weighted basis it is at new highs in nominal terms and nearly that high in real terms.

We expect the dollar to continue to remain strong and potentially appreciate. Investors continue to favor holding U.S. dollar-denominated securities due to the wide interest rate differentials with other major countries and potential for investment gains in the U.S. economy.

U.S. interest rates are high compared to those in other countries

The dollar's strength can help offset some of the inflationary pressures in the economy and from tariffs. It also makes U.S. Treasuries attractive to hold, helping to mitigate some of the upward pressure on yields.

Overall, the next few months are likely to see yields remain elevated or move higher. In the longer run, as the outlook clears about policy, yields should stabilize and potentially move lower in the second half of 2025. For now, however, we are cautious about interest rate risk.

Global stocks and economy: Another yen carry trade unwind?

Trump's pick for Treasury secretary, hedge fund manager Scott Bessent, has proposed a "3-3-3" economic plan for the U.S. that echoes Japan's "three arrows" plan, part of the "Abenomics" policies launched at the end of 2012. The details of the plans differ, but Bessent's enthusiasm for Japan's economic program is reflected in an essay he wrote in 2022, which includes this recollection from 2012: "I'm not sure whether it will work, but it will be the market ride of a lifetime." The chart below suggests that he wasn't wrong about that.

Japan's stock market reclaimed its prior peak in 2024

What is next for Japan? One of the 2012 "three arrows" was easing monetary policy to bring back inflation. That era finally ended last year with inflation appearing to be sustainable and the Bank of Japan (BOJ) lifting rates from negative territory. Now, there could be a chance of another rate hike announcement at the BOJ's next meeting on January 24. The last time the BOJ hiked rates, in July 2024, it sparked a three-day selloff amounting to a -20% move for the MSCI Japan Index and -6% move for the S&P 500 Index as the yen carry trade unwound. Those who had positioned themselves against a rising yen had to quickly sell assets to close out their short positions in the Japanese currency.

The markets are divided on the prospects for another rate hike at the January meeting. Some market participants believe the BOJ could hold off for now amid uncertainty over U.S. trade policy toward Japan under the Trump administration. Yet, because Japanese companies are the U.S.'s largest source of foreign direct investment and the second-largest foreign employer in the United States, Japan may be better positioned than most U.S. trading partners to withstand U.S. policy changes.

The summary of opinions for the December 2024 BOJ meeting hinted that some board members see a need to increase borrowing costs sooner rather than later. And BOJ Governor Kazuo Ueda on January 6 sent a fresh reminder that he's planning to raise rates should the economy continue to improve this year. However, he kept his options open on the timing of the next rate hike by saying it will depend on the economy, inflation, the outlook for wage growth, and financial conditions.

That uncertainty has kept the yen at a relatively weak level thus far. The yen could jump if the BOJ hikes rates. If so, might we see another sharp selloff in stocks? That seems unlikely. Current market vulnerability to a reversal in the yen isn't the same as it was in July 2024. Speculators' yen positioning is close to neutral, unlike the record short positions ahead of the BOJ hike last July, as you can see in the chart below.

Yen speculators current positioning close to neutral

Nevertheless, risks of a longer-term unwind remain. In his 2022 essay, Bessent warned about a potential global financial crisis stemming from a reversal of the yen carry trade, focusing not on short-term speculators, but the amount of Japanese capital that has funded other longer-term investments both in and outside of Japan that may need to be liquidated to repay borrowings as costs rise.

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